Chapter 8 — Other Considerations
Chapter 8 — Other Considerations
8.1 Prior-Period Adjustments
ASC 260-10
Prior-Period Adjustments
55-15 If authoritative literature requires that a restatement of the results of operations of a prior period be included in the income statement or summary of earnings, then EPS data given for the prior period or periods shall be restated. The effect of the restatement, expressed in per-share terms, shall be disclosed in the period of restatement.
55-16 Restated EPS data shall be computed as if the restated income or loss had been reported originally in the prior period or periods. Thus, it is possible that common stock assumed to be issued upon exercise, conversion, or issuance of potential common shares in accordance with the provisions of this Subtopic may not be included in the computation of restated EPS amounts. That is, retroactive restatement of income from continuing operations could cause potential common shares originally determined to be dilutive to become antidilutive pursuant to the control number provision in paragraph 260-10-45-18. The reverse also is true. Retroactive restatement also may cause the numerator of the EPS computation to change by an amount that differs from the amount of the retroactive adjustment.
An entity may restate its previously reported net income as a result of the
correction of an error. In addition, an entity may retrospectively adjust previously
reported net income for other reasons (e.g., a change in accounting principle). In
these situations, previously reported amounts of basic and diluted EPS must be
adjusted as if the restated or retrospectively adjusted income or loss had been
originally reported in the prior period(s). As noted in ASC 260-10-55-16, a
restatement or retrospective adjustment of previously reported net income may affect
whether potential common shares are dilutive in the calculation of diluted EPS in
accordance with the antidilution sequencing requirements, as discussed in Section 4.1.2. Furthermore,
since the numerator used in the calculation of basic and diluted EPS is affected, an
entity would be required to recalculate EPS amounts under the two-class method, if
applicable. The effect of the restatement (or adjustment) should be disclosed in
per-share amounts in the period of the restatement. See Section 9.2.2.2 for discussion of disclosure
considerations.
Subsequent events and other information obtained after the date on
which an entity’s financial statements were issued or available to be issued, when
such events and information do not result in a restatement of the entity’s previous
financial statements, have no impact on previously reported amounts of EPS. For
example, if a contingency is resolved in a subsequent period and that resolution
would have altered a prior-period calculation of EPS if it had been resolved in that
prior period, the resolution of the contingency does not result in the requirement
to restate previously reported EPS amounts. An entity may, however, be required to
disclose pro forma EPS amounts. See Section B.2.2 for more information.
8.2 Shareholder Distributions
8.2.1 Stock Dividends and Stock Splits
ASC 260-10
Stock Dividends or Stock Splits
55-12 If the number of common
shares outstanding increases as a result of a stock
dividend or stock split (see Subtopic 505-20) or
decreases as a result of a reverse stock split, the
computations of basic and diluted EPS shall be adjusted
retroactively for all periods presented to reflect that
change in capital structure. If changes in common stock
resulting from stock dividends, stock splits, or reverse
stock splits occur after the close of the period but
before the financial statements are issued or are
available to be issued (as discussed in Section
855-10-25), the per-share computations for those and any
prior-period financial statements presented shall be
based on the new number of shares. If per-share
computations reflect such changes in the number of
shares, that fact shall be disclosed.
Stock splits and reverse stock splits affect the number of common shares outstanding as well as the per-share price of an entity’s common shares, and entities generally enter into such transactions when they wish to manage the per-share price of their common stock. However, stock splits and reverse stock splits themselves have no immediate impact on an entity’s total market capitalization.
ASC 505-20-20 defines a “stock split” as follows:
An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price and, thereby, of obtaining wider distribution and improved marketability of the shares. Sometimes called a stock split-up.
A reverse stock split is merely the inverse of a stock split. In a reverse stock
split, an entity reduces, instead of increases, the total number of shares of
common stock outstanding by dividing the current quantity of outstanding shares
by the amount of the split (e.g., in a 1-for-10 reverse stock split for an
entity with 10 million outstanding common shares, the reverse stock split
reduces the number of outstanding shares to 1 million). A transaction that
either increases or reduces the total number of common shares outstanding can be
a stock split or reverse stock split only if the change is made proportionately
to all shareholders. As discussed in Section 8.6.2, certain reclassifications
of common equity that occur in conjunction with an IPO are accounted for in the
same manner as a stock split or reverse stock split.
Stock dividends may be thought of as having some of the characteristics of a cash dividend but are treated as a stock split for EPS purposes. ASC 505-20-15-3 states that the following types of distributions or issuances to shareholders should not be considered stock dividends:
- Shares of another corporation held as an investment
- Shares of a different class
- Rights to subscribe for additional shares [see Section 8.2.2]
- Shares of the same class in cases in which each shareholder is given an election to receive cash or shares [see Section 8.3.3].
For stock dividends, stock splits, and reverse stock splits, ASC
260-10-55-12 requires entities to retrospectively adjust previously reported EPS
amounts and to provide appropriate disclosures about this matter (see Section 9.2.1.3). One
often-overlooked provision of ASC 260 is the requirement for entities to make
this retrospective adjustment when there are changes in the number of
outstanding shares of common stock resulting from stock dividends, stock splits,
or reverse stock splits that occur after the close of the period but before the
financial statements are issued or are available to be issued.
Post-balance-sheet stock dividends and stock splits are discussed in Section 8.2.1.1.
Since stock dividends, stock splits, and reverse stock splits have the same
proportionate impact on both the number of outstanding common shares and the
share price, an entity that is making such retrospective adjustments to EPS will
typically not be required to perform detailed recalculations of the impact of
potential common shares on diluted EPS or to reallocate undistributed earnings
under the two-class method, provided that the entity has standard antidilution
provisions in all of its contracts that represent potential common shares. In
other words, the impact on previously reported basic and diluted EPS will be
reflected through a mere proportionate change in the denominators in the EPS
calculations. The example below illustrates this point.
Example 8-1
Impact of Stock Split on EPS
Entity X has a capital structure consisting of outstanding common stock, outstanding preferred stock classified in permanent equity, equity-classified unvested stock awards granted to employees that are considered participating securities, and equity-classified stock options granted to employees that are not considered participating securities. Both the unvested stock awards and the stock options contain standard antidilution provisions that would be applicable in the event of a stock split. For diluted EPS presented for all periods, X has concluded that the unvested share awards are more dilutive under the two-class method than they are under the treasury stock method. Entity X previously reported basic and diluted EPS for the three years in the period ended December 31, 20X8, as follows (all amounts are in millions):
During 20X9, Entity X declares and executes a 2-for-1 stock split. The EPS amounts for the previously reported periods, as retrospectively adjusted for the stock split, are as follows:
On the basis of the facts in this scenario, the stock split has no impact on the numerator. Since the stock split results in a retrospective adjustment to both the outstanding share amounts and the stock price, it also results in an increase to the denominator by a factor of 2 and a decrease in reported EPS by a factor of 0.5 (subject to rounding).
Connecting the Dots
If an entity effectuates a stock dividend, stock split, or reverse stock split and does not have standard antidilution provisions in all of its contracts that represent potential common stock, the holders of the potential common stock, unlike holders of common stock, are positively or adversely affected by the transaction. In these situations, the entity would need to perform detailed recalculations of basic and diluted EPS to appropriately reflect the impact that the stock dividend, stock split, or reverse stock split had on the dilutive effect of potential common stock and the allocation of undistributed earnings under the two-class method.
8.2.1.1 Post-Balance-Sheet Stock Dividends and Stock Splits
If a stock dividend, stock split, or reverse stock split is consummated after the close of the financial reporting period but before the financial statements are issued or available to be issued, the per-share amounts for EPS calculations related to prior periods and the current period must be retrospectively adjusted on the basis of the new number of shares of common stock. In applying this guidance, an entity must consider what constitutes the (1) issuance of financial statements (or those that are available to be issued) and (2) consummation of a post-balance-sheet stock dividend, stock split, or reverse stock split. Such considerations are relevant because an entity would not retrospectively reflect the impact of a post-balance-sheet stock dividend, stock split, or reverse stock split unless it is consummated before the entity’s financial statements are issued or available to be issued.
8.2.1.1.1 Financial Statements Are Issued or Available to Be Issued
ASC 855-10-25-1A and 25-2 state that an SEC filer (or a conduit bond obligor for
conduit debt securities that are traded in a public market) should
evaluate subsequent events through the date on which financial
statements are issued and that all other entities should evaluate
subsequent events through the date on which financial statements are
available to be issued. These defined terms are relevant to the
evaluation of the accounting consequences of a stock dividend, stock
split, or reverse stock split that occurs after the date of the
financial statements.
In addition, the SEC has provided guidance on assessing when the financial
statements of an SEC registrant have been “issued.” Specifically, ASC
855-10-S99-2 states, in part:
Generally, the [SEC] staff believes that financial statements are
“issued” as of the date they are distributed for general use and
reliance in a form and format that complies with generally
accepted accounting principles (GAAP) and, in the case of annual
financial statements, that contain an audit report that
indicates that the auditors have complied with generally
accepted auditing standards (GAAS) in completing their audit.
Issuance of financial statements then would generally be the
earlier of when the annual or quarterly financial statements are
widely distributed to all shareholders and other financial
statement usersFN4 or filed with the Commission. Furthermore,
the issuance of an earnings release does not constitute issuance
of financial statements because the earnings release would not
be in a form and format that complies with GAAP and GAAS.
____________________
FN4 Posting financial statements to a registrant’s web
site would be considered wide distribution to all shareholders
and other financial statement users if the registrant uses its
web site to disclose information to the public in a manner
consistent with the requirements of Regulation FD. See the
Commission’s interpretive guidance in Exchange Act Release No.
58288 (Aug. 7, 2008).
SEC Considerations
On the basis of the SEC’s guidance in ASC 855-10-S99-2 and the practices of SEC registrants, an entity’s annual financial statements are not considered “issued” until the entity has filed a Form 10-K, since press releases are not in a form and format that complies with GAAP and GAAS and entities generally do not disseminate annual reports to shareholders with an audit report that complies with PCAOB standards before filing the Form 10-K. With respect to quarterly financial information, on the basis of the practices of SEC registrants, interim financial statements are also not typically considered “issued” until a Form 10-Q has been filed. However, because an SEC registrant’s quarterly financial statements must be reviewed by an independent registered public accounting firm before being filed on a Form 10-Q but the Form 10-Q does not need to include an independent accountant’s review report indicating the completion of a review in accordance with PCAOB standards, it is possible that an entity’s interim financial statements could be considered “issued” before the Form 10-Q is filed. For quarterly financial statements to be considered “issued” before the filing of the Form 10-Q, an entity must have widely disseminated the required quarterly financial statements and disclosures (i.e., balance sheets, income statements, cash flow statements, and all the disclosures that will be included in the Form 10-Q) in a form and format that complies with GAAP. In practice, these conditions are not met through issuance of a press release and are typically also not met through other forms of dissemination before the date on which the Form 10-Q has been filed.
The common practices of entities not to disseminate the information necessary for “issuance” of financial statements to occur before the filing of Form 10-K or Form 10-Q exist, in part, because of Rules 10b-5 and 12b-20 of the Exchange Act, which specify that financial statements must not be misleading as of the date on which they are filed with the SEC.
8.2.1.1.2 Consummation of Stock Dividend, Stock Split, or Reverse Stock Split
A stock dividend, stock split, or reverse stock split is considered to have been
consummated once (1) it has been declared, approved by all necessary
parties (e.g., board of directors, shareholders), and distributed and
(2) the common shares are trading on a post-split or post-dividend
basis. EPS should not be retrospectively adjusted as a result of a stock
dividend, stock split, or reverse stock split if the common shares do
not trade on a post-split or post-dividend basis until after the
financial statements are issued (or, for non-SEC filers, available to be
issued). For larger distributions, this typically occurs the day after
the dividend or split has been distributed. If an entity has declared a
stock dividend, stock split, or reverse stock split before its financial
statements are issued (or, for non-SEC filers, available to be issued),
but the common shares do not trade on a post-split or post-dividend
basis until afterwards, EPS should be calculated for all periods by
using the number of common shares on a pre-split basis and the entity
should disclose the post-split impact of the stock dividend, stock
split, or reverse stock split in the financial statements. The entity
should also disclose the significant terms and timing of the pending
stock dividend, stock split, or reverse stock split. See Section 9.2.1.3
for further discussion of presentation and disclosure.
Connecting the Dots
An entity is encouraged to consult with its independent accountants when it believes that it should not reflect the impact of a stock dividend, stock split, or reverse stock split in its financial statements to be filed on Form 10-K or Form 10-Q and its common stock is trading on a post-split basis as of the date of the filing of the Form 10-K or Form 10-Q.
8.2.1.1.3 Reissuances of Financial Statements
An entity may reissue its financial statements for various reasons (e.g., to
correct an error in previously reported financial statements).1 In addition, financial statements that were previously issued or
available to be issued may be included, or incorporated by reference, in
a registration statement filed with the SEC. The evaluation of
subsequent events pertaining to financial statements that will be
included, or incorporated by reference, in a registration stated filed
with the SEC is subject to the SEC’s guidance. According to the SEC’s
guidance, when financial statements are included, or incorporated by
reference, in a registration statement, the entity may need to adjust
the financial statements, or provide supplemental disclosures, as a
result of certain events occurring after the date on which the financial
statements were originally issued or available to be issued. Those
events include, but are not limited to, a change in accounting
principle; change in reportable segments; discontinued operation; and
stock dividend, stock split, or reverse stock split that is consummated
or declared after the financial statements were originally issued or
available to be issued.
8.2.1.1.3.1 Non-SEC Filers
ASC 855-10
Revised Financial Statements
50-4 Unless the entity is an
SEC filer, an entity shall disclose in the revised
financial statements the dates through which
subsequent events have been evaluated in both of
the following:
-
The issued or available-to-be-issued financial statements
-
The revised financial statements.
50-5 Revised financial statements are considered reissued financial statements. For guidance on the recognition of subsequent events in reissued financial statements, see paragraph 855-10-25-4.
For a non-SEC filer, stock dividends, stock splits, or reverse stock splits that have been consummated after the date on which financial statements were originally available to be issued generally should be reflected retrospectively in the entity’s financial statements if they are subsequently considered revised financial statements. This guidance is consistent with that in ASC 855, which indicates that revised financial statements are considered reissued financial statements.
The financial statements of a non-SEC filer may be reissued for various
reasons.2 For example, a non-SEC filer’s financial statements may be
included in a filing with the SEC because the entity is acquired by
an SEC registrant or is a significant equity method investee of an
investor that is an SEC registrant. A non-SEC filer could also file
a registration statement with the SEC for an initial offering of
securities. Various facts and circumstances may be relevant to a
non-SEC filer’s inclusion of financial statements in a registration
statement or other filing with the SEC. Such an entity should
consult with its independent accountants regarding the appropriate
presentation and disclosure for a stock dividend, stock split, or
reverse stock split that has been consummated or declared after the
original date on which the financial statements were available to be
issued. As noted below, when financial statements are included
(i.e., reproduced) in a registration statement filed with the SEC,
such financial statements must generally be retrospectively adjusted
to reflect a stock dividend, stock split, or reverse stock split
that occurred after the original date on which the financial
statements were available to be issued.
8.2.1.1.3.2 SEC Filers
An SEC filer must consider the SEC’s guidance when determining whether its financial statements are “reissued.” Although the application of that guidance will depend on an entity’s particular facts and circumstances, the following are a few considerations:
- Section 13500 of the FRM indicates that the SEC staff would ordinarily “not require retrospective revision of previously filed financial statements that are incorporated by reference into a registration or proxy statement for reasons solely attributable to a stock split.” Further, Section 13500 notes that “[i]nstead, the registration or proxy statement may include selected financial data that includes relevant per share information for all periods, with the stock split prominently disclosed.” While this guidance refers only to stock splits, it would apply equally to a stock dividend or reverse stock split that must be retrospectively adjusted under ASC 260. Note that this view of the staff typically only applies when financial statements are incorporated by reference into a registration statement or proxy statement; an SEC registrant would generally be expected to retrospectively revise historical financial statements for a stock split, stock dividend, or reverse stock split when financial statements are included (i.e., reproduced) in a registration statement or proxy statement.
- When an SEC registrant retrospectively adjusts previously issued financial statements as a result of the correction of an error or a retrospective accounting change, including, but not limited to, a change in reportable segments or a discontinued operation, any stock dividend, stock split, or reverse stock split that has been consummated since the original issuance of the financial statements should be retrospectively adjusted in the entity’s financial statements and appropriate disclosures should be provided before reissuance.
8.2.2 Rights Issues
ASC 260-10
Rights Issues
55-13 A rights issue whose
exercise price at issuance is less than the fair value
of the stock contains a bonus element that is somewhat
similar to a stock dividend. If a rights issue contains
a bonus element and the rights issue is offered to all
existing stockholders, basic and diluted EPS shall be
adjusted retroactively for the bonus element for all
periods presented. If the ability to exercise the rights
issue is contingent on some event other than the passage
of time, the provisions of this paragraph shall not be
applicable until that contingency is resolved.
55-14 The number of common shares used in computing basic and diluted EPS for all periods prior to the rights issue shall be the number of common shares outstanding immediately prior to the issue multiplied by the following factor: (fair value per share immediately prior to the exercise of the rights)/(theoretical ex-rights fair value per share). Theoretical ex-rights fair value per share shall be computed by adding the aggregate fair value of the shares immediately prior to the exercise of the rights to the proceeds expected from the exercise of the rights and dividing by the number of shares outstanding after the exercise of the rights. Example 5 (see paragraph 260-10-55-60) illustrates that provision. If the rights themselves are to be publicly traded separately from the shares prior to the exercise date, fair value for the purposes of this computation shall be established at the close of the last day on which the shares are traded together with the rights.
A rights issue represents an offer to existing common stockholders to purchase additional shares of common stock for a specified amount for a given period. The purchase price is generally less than the fair value of the entity’s common stock. An entity may have a rights issue for various reasons, such as raising additional capital or preventing a takeover. Further, a rights issue:
- Is effectively a dividend to existing common stockholders that allows them to subscribe to purchase additional shares of common stock.
- Offsets dilution to an entity’s existing shareholders and may be favorable to entities for income tax reasons and because stock exchanges may not require the entity’s common shareholders to approve certain rights issuances.
- May be executed through an underwriting by a broker-dealer.
A rights issue may contain a bonus element that is akin to a stock dividend. That element must be treated in the same manner as a stock dividend. Therefore, when a rights issue is offered “in the money,” basic and diluted EPS should be retrospectively adjusted for the portion of the issuance that reflects a stock dividend (see Section 8.2.1). ASC 260-10-55-60 and 55-61 illustrate the impact on EPS for a rights issue that contains a bonus element. (Note that a rights issue whose exercise is contingent upon the occurrence of a specified event other than the mere passage of time would not be recognized for accounting purposes until the contingency is resolved.)
ASC 260-10
Example 5: Rights Issues
55-60 This Example illustrates the provisions for stock rights issues that contain a bonus element as described in paragraphs 260-10-55-13 through 55-14. This Example has the following assumptions:
- Net income was $1,100 for the year ended December 31, 20X0.
- 500 common shares were outstanding for the entire year ended December 31, 20X0.
- A rights issue was offered to all existing shareholders in January 20X1. The last date to exercise the rights was March 1, 20X1. The offer provided 1 common share for each 5 outstanding common shares (100 new shares).
- The exercise price for the rights issue was $5 per share acquired.
- The fair value of 1 common share was $11 at March 1, 20X1.
- Basic EPS for the year 20X0 (prior to the rights issuance) was $2.20.
55-61 As a result of the bonus element in the January 20X1 rights issue, basic and diluted EPS for 20X0 will have to be adjusted retroactively. The number of common shares used in computing basic and diluted EPS is the number of shares outstanding immediately prior to the rights issue (500) multiplied by an adjustment factor. Prior to computing the adjustment factor, the theoretical ex-rights fair value per share must be computed. Those computations follow.
Diluted EPS would be adjusted retroactively by adding 50 shares to the denominator that was used in computing diluted EPS prior to the restatement.
ASC 260 does not address how an entity should incorporate the impact of a rights
issue into the calculations of basic and diluted EPS for financial reporting
periods before the most recent period. However, it is acceptable to calculate a
single adjustment factor and use that amount to retrospectively adjust all
previously reported EPS amounts. That is, the original outstanding shares of
common stock used in each prior-period EPS calculation would be adjusted by the
rights issue adjustment factor that is used to adjust basic and diluted EPS in
the most recent reporting period.
Footnotes
1
In this context, “reissue” is considered in the
general sense.
2
See footnote
1.
8.3 Certain Issuances of Common Stock
8.3.1 Common Stock Subscriptions
ASC 260-10
Partially Paid Shares and Partially Paid Stock Subscriptions
55-23 If an entity has common shares issued in a partially paid form (permitted in some countries) and those shares are entitled to dividends in proportion to the amount paid, the common-share equivalent of those partially paid shares shall be included in the computation of basic EPS to the extent that they were entitled to participate in dividends. Partially paid stock subscriptions that do not share in dividends until fully paid are considered the equivalent of warrants and shall be included in diluted EPS by use of the treasury stock method. That is, the unpaid balance shall be assumed to be proceeds used to purchase stock under the treasury stock method. The number of shares included in diluted EPS shall be the difference between the number of shares subscribed and the number of shares assumed to be purchased.
Stock subscriptions are a mechanism that allows an entity to offer employees and
other investors the ability to purchase shares of the entity’s common stock,
typically over a period of time and without a broker’s commission. The impact of
a stock subscription agreement on basic and diluted EPS will depend on the
extent to which the investor is entitled to participate in dividends before the
subscription agreement is fully paid and the shares of common stock are
outstanding. The table below summarizes the EPS implications of stock
subscription agreements that must be settled in common stock.
Table 8-1
Impact on: | ||
---|---|---|
Terms and Payment Status | Basic EPS(a),(b) | Diluted EPS(a),(b) |
Fully Unpaid Stock Subscription Agreement | ||
Investor is entitled to participate in dividends on the basis of the number of common shares to be acquired. | The subscription agreement is treated as an option that is a participating security. The two-class method is applied. | The subscription agreement is treated as an option that is a participating security. The more dilutive of the two-class method or the treasury stock method is applied. |
Investor is not entitled to participate in any dividends before making payments on the subscription agreement. | No impact. | The subscription agreement is treated as an option that is not a participating security. The treasury stock method is applied. |
Partially Paid Stock Subscription Agreement | ||
Investor is entitled to participate in dividends on the basis of the number of common shares to be acquired. | Paid portion — The common share equivalent of the partially paid shares is treated as outstanding common stock.
Unpaid portion — The unpaid portion of the subscription agreement is treated as an option that is a participating security; therefore, the two-class method is applied. | Paid portion — The common share equivalent of the partially paid shares is treated as outstanding common stock.
Unpaid portion — The unpaid portion of the subscription agreement is treated as an option that is a participating security. The more dilutive of the two-class method or the treasury stock method is applied. |
Investor is entitled to participate in dividends only in proportion to the amount of the stock subscription paid. | Paid portion — The common share equivalent of the partially paid shares is treated as outstanding common stock.
Unpaid portion — No impact. | Paid portion — The common share equivalent of the partially paid shares is treated as outstanding common stock.
Unpaid portion — The unpaid amount of the subscription agreement is treated as an option that is not a participating security. The treasury stock method is applied. |
Investor is not entitled to participate in any dividends until the stock subscription is fully paid. | No impact.(c) | The subscription agreement is treated as an option that is not a participating security. The treasury stock method is applied.(c) |
Notes to Table: (a) In this table, it is assumed that an entity has entered into the stock
subscription agreement with an investor. If the entity
has entered into the stock subscription agreement with
an employee, a nonemployee in return for goods and
services, or a customer, the entity should consider the
guidance on share-based payment arrangements. See
Section 7.1 for further discussion. (b) The table does not apply to situations in which an entity receives a note
receivable in exchange for shares of common stock that
are legally issued and outstanding. See Section
8.3.2 for more information. (c) It may seem that the two-class method should be applied to the paid portion
of the stock subscription agreement because the investor
has paid for shares of common stock that are not
entitled to dividends. However, since the shares of
common stock will be entitled to dividends only when the
stock subscription agreement is fully paid, the
two-class method is not applied because the investor
will presumably have paid less for the shares of common
stock because of their inability to participate in
dividends before full payment. Furthermore, applying the
two-class method should result in a similar impact on
basic and diluted EPS because the shares of common stock
underlying the stock subscription agreement (i.e., the
participating security) will not be entitled to either
distributed or undistributed earnings. |
The two examples below illustrate the accounting for basic and diluted EPS for a
common stock subscription.
Example 8-2
Common Stock Subscription Agreement — Counterparty Is Entitled to Dividends on Paid Portion
Company Q enters into a stock subscription agreement with Company R. The agreement has the following key terms:
- On January 1, 20X1, R agrees to purchase 20,000 common shares of Q over a four-year period. Under this agreement, R will purchase 5,000 common shares per year.
- The purchase price of the common shares is $40 per share.
- The subscription agreement requires R to pay $10 per share acquired per year, and the shares acquired for each year must be paid for on the first day of each year.
- Company R is not entitled to receive dividends on the unpaid portion of the common shares to be purchased under the subscription agreement but is entitled to participate in dividends on the number of common share equivalents paid for (i.e., the paid portion).
Because R is only entitled to dividends on the paid portion of the subscription agreement, in accordance with the guidance in Table 8-1, the paid portion of the subscription agreement is treated as outstanding common shares and the unpaid portion is treated as an option that is not a participating security. The treasury stock method applies to calculating the impact of the subscription agreement on diluted EPS. The calculation under the treasury stock method for Q’s year ended December 31, 20X1, on the basis of a $45 weighted-average price of Q’s common stock, is as follows:
Note that the calculation of the weighted-average options outstanding would be more complex if the counterparty made payments on the stock subscription agreement during a reporting period. In addition, if the counterparty was entitled to receive dividends on the unpaid portion, the options equivalent outstanding would represent a participating security to which an entity must apply the more dilutive of the treasury stock method or the two-class method of calculating diluted EPS.
Example 8-3
Stock Subscription Agreement — Counterparty Is Not Entitled to Dividends on Paid Portion
Assume the same facts as in the example above, except that Company R is not
entitled to participate in any dividends until the
subscription agreement is paid in full. Further, note
that the investor in this scenario would presumably pay
less per share than the one in the example above.
Since R is not entitled to dividends on the paid portion of the subscription agreement, in accordance with the guidance in Table 8-1, no shares are treated as outstanding in the calculation of basic EPS and the subscription agreement is treated as an option that is not a participating security. The treasury stock method applies to calculating the impact of the subscription agreement on diluted EPS. The weighted-average options equivalent outstanding would be the entire amount of 20,000 common shares to be issued under the subscription agreement. The calculation under the treasury stock method for Q’s year ended December 31, 20X1, on the basis of a $45 weighted-average price of Q’s common stock, is as follows:
Note that the impact of the subscription agreement on the denominator of diluted
EPS is the same as in the example above, in which 5,000
common shares are included in the denominator of basic
EPS and 1,667 incremental common shares are included in
the denominator of diluted EPS.
8.3.2 Common Stock Issued for Note Receivable
In a transaction that is not subject to ASC 718, an entity may issue shares of
common stock that are legally outstanding, not subject to any stated vesting
conditions, and entitled to dividends in the same manner as all other
outstanding shares of common stock in return for a note receivable from the
investor. The note receivable may be recourse or nonrecourse. ASC 260 does not
provide specific guidance on situations in which an entity has issued, in return
for a note receivable, shares of common stock to an investor that are legally
outstanding and not subject to any vesting conditions.
Under U.S. GAAP, an entity that issues common stock in return for a note
receivable (in a transaction not subject to ASC 718) is generally required to
present the note receivable within contra-equity in accordance with ASC
505-10-45-2. It is acceptable, for EPS purposes, for an entity to treat the
shares of common stock that are issued and legally outstanding in the same
manner as an option if the entity concludes, on the basis of the terms of the
contract and the relevant laws, that it (1) can cancel the shares of common
stock if the investor defaults on the note receivable and (2) intends to
exercise this cancellation right. Since the shares of common stock are entitled
to dividend rights while outstanding, that option would be considered a
participating security and therefore may have the same impact as if it were
treated as an outstanding share. However, the arrangement should not be treated
as an option for EPS purposes if the entity is unable to conclude that it either
(1) has the legal right to cancel the shares of common stock if the investor
defaults on the note receivable or (2) does not intend to exercise this legally
available cancellation right. Rather, in such circumstances, the note receivable
should be considered separate from the shares of common stock, which should be
considered outstanding shares in the calculation of basic and diluted EPS. In
either situation, the EPS accounting would not affect the requirement to
classify the note receivable as contra-equity under GAAP.
When shares of common stock are issued to a grantee in return for a note
receivable in a share-based payment arrangement subject to ASC 718, the
accounting depends, in part, on whether the note is recourse or nonrecourse. If
the note is nonrecourse, the award is accounted for as an option until the note
is repaid. As a result, until the note is repaid, the shares would be (1)
excluded from the denominator in the calculation of basic EPS and (2) included
in the denominator in the calculation of diluted EPS in accordance with the
treasury stock method. The arrangement could still affect basic EPS if the award
is considered a participating security. See Section 3.11 of Deloitte’s Roadmap
Share-Based Payment
Awards for further discussion of the treatment of common
shares issued for notes under ASC 718.
Connecting the Dots
When a note received from an investor in exchange for the issuance of shares of common stock is considered the equivalent of an option for EPS purposes and the transaction is not within the scope of ASC 718, the exercise price should typically consist of the principal amount and interest on the note receivable (therefore, no interest income is recognized in income). It would not be acceptable to consider the arrangement as representing an option for EPS purposes if interest income has been recognized in income.
8.3.3 Distributions That Are Considered Issuances of Common Stock
Certain entities that are required to periodically distribute a certain portion
of their taxable income give their common shareholders the ability to elect to
receive their entire distribution in cash or common shares of an equivalent
value, with a potential limitation on the total amount of cash that shareholders
may receive in the aggregate. ASC 505-20-15-3(d) and 15-3A address the
accounting for situations in which an entity declares dividends to common
shareholders that may be paid in cash or shares at the election of the
shareholders. ASC 505-20-15-3(d) and 15-3A indicate that a stock dividend does
not include a distribution for which each shareholder is given an election to
receive either cash or shares of common stock of an equivalent value, even if
there is a potential limitation on the total amount of cash that all
shareholders can elect to receive in the aggregate. In these situations, the
common stock portion of the distribution should be accounted for as a share
issuance. Thus, the common stock portion will be reflected in the calculation of
basic EPS prospectively (i.e., from the date of issuance) rather than being
reflected retrospectively in accordance with the treatment of stock dividends.
Although basic EPS is not affected before the issuance of the common shares that
are delivered in satisfaction of the dividend, there is an impact on diluted
EPS. ASC 260-10-45-45 through 45-47 apply to the calculation of diluted EPS for
a contract that may be settled in stock or cash. This guidance must be applied
during the period between the declaration date and the dividend payment date.
The example below illustrates the application of this guidance.
Example 8-4
Diluted EPS for Distribution That May Be Received in Cash or Common Shares at the Option of Investors
Company A, a real estate investment trust, is a calendar-year entity with quarterly periods ending on March 31, June 30, September 30, and December 31 of each calendar year. On March 1, 20X1, A’s board of directors declares a regular quarterly dividend of $1.00 per share, payable on April 30, 20X1, to shareholders of record on March 15, 20X1. As of the record date, A has 100 million common shares outstanding. In declaring the dividend, the board of directors determines that it will be paid in a combination of cash and common stock. The significant terms of the declared dividend are as follows:
- Each investor can elect to receive payment of the dividend in cash or common stock subject to a maximum amount of cash paid on distribution of 25 percent of the aggregate distribution (or $25 million).
- For the common stock distribution to qualify as a taxable dividend, each common shareholder must have the option to elect to receive its distribution in either cash or common shares and shareholder elections must be received by April 15, 20X1.
- For the portion of the distribution paid in common shares, A will deliver a number of common shares that have the same monetary value as the cash dividend amount; the number of common shares calculated is based on A’s closing share prices for the five-day trading period ending five days before the payment date of the dividend (i.e., the five-day trading period ending on April 25, 20X1).
The accounting guidance on diluted EPS that applies to the payment of this
dividend is as follows:
-
Since 75 percent of the distribution is payable in common stock (because of the limitation on the cash portion) these shares must be reflected in the denominator in the calculation of diluted EPS.
-
The remaining 25 percent of the distribution is subject to the guidance in ASC 260-10-45-45 through 45-47. In accordance with this guidance, A cannot overcome the presumption of share settlement. Therefore, A must assume that the remaining 25 percent is paid in shares.
Because these shares are issuable for little or no consideration, it is
appropriate to apply the contingently issuable share
method to calculate diluted EPS. In accordance with ASC
260-10-45-52, A must assume that the end of the
reporting period is the end of the contingency period
(i.e., the averaging period used to determine the number
of common shares issuable). Therefore, A must use the
average of the closing stock prices over the five-day
trading period ending five days before the end of the
reporting period.
Assume that the closing share prices of A’s stock for the five-day trading period ending five days before March 31, 20X1, were as follows:
- March 20 — $35.25.
- March 21 — $34.88.
- March 22 — $35.00.
- March 23 — $35.18.
- March 26 — $35.32.
These closing prices result in an average price of $35.13 ($35.25 + $34.88 + $35.00 + $35.18 + $35.32 = $175.63 ÷ 5 = $35.13). On the basis of this average price, as of March 31, 20X1, A would issue 2,846,570 shares of common stock ($100,000,000 ÷ $35.13 = 2,846,570). This number of common shares should be included in the denominator of diluted EPS on a weighted-average basis as follows:
If, however, the terms of the dividend indicate that 75 percent will be settled
in shares and 25 percent in cash, with the only
variability involving which shareholders receive cash
and which receive shares (and the number of shares
issuable to make the $75 million payment), the dilutive
impact would be limited to the requirement to pay $75
million of the dividend through the issuance of common
shares.
8.3.4 Nominal Issuances
8.3.4.1 EPS Accounting
SEC Staff Accounting Bulletins
SAB Topic 4.D,
Earning per Share Computations in an Initial
Public Offering [Reproduced in ASC
260-10-S99-1]
Facts: A
registration statement is filed in connection with
an initial public offering (IPO) of common stock.
During the periods covered by income statements that
are included in the registration statement or in the
subsequent period prior to the effective date of the
IPO, the registrant issued for nominal
consideration1 common stock, options or
warrants to purchase common stock or other
potentially dilutive instruments (collectively,
referred to hereafter as “nominal issuances”).
Prior to the effective date of FASB
ASC Topic 260, Earnings Per Share, the staff
believed that certain stock and warrants2
should be treated as outstanding for all reporting
periods in the same manner as shares issued in a
stock split or a recapitalization effected
contemporaneously with the IPO. The dilutive effect
of such stock and warrants could be measured using
the treasury stock method.
Question 1:
Does the staff continue to believe that such
treatment for stock and warrants would be
appropriate upon adoption of FASB ASC Topic 260?
Interpretive
Response: Generally, no. Historical EPS should
be prepared and presented in conformity with FASB
ASC Topic 260.
In applying the requirements of FASB
ASC Topic 260, the staff believes that nominal
issuances are recapitalizations in substance. In
computing basic EPS for the periods covered by
income statements included in the registration
statement and in subsequent filings with the SEC,
nominal issuances of common stock should be
reflected in a manner similar to a stock split or
stock dividend for which retroactive treatment is
required by FASB ASC paragraph 260-10-55-12. In
computing diluted EPS for such periods, nominal
issuances of common stock and potential common
stock3 should be reflected in a manner similar to a
stock split or stock dividend.
Registrants are reminded that
disclosure about materially dilutive issuances is
required outside the financial statements. Item 506
of Regulation S-K requires presentation of the
dilutive effects of those issuances on net tangible
book value. The effects of dilutive issuances on the
registrant’s liquidity, capital resources and
results of operations should be addressed in
Management’s Discussion and Analysis.
Question 2:
Does reflecting nominal issuances as outstanding for
all historical periods in the computation of
earnings per share alter the registrant’s
responsibility to determine whether compensation
expense must be recognized for such issuances to
employees?
Interpretive
Response: No. Registrants must follow GAAP in
determining whether the recognition of compensation
expense for any issuances of equity instruments to
employees is necessary.4 Reflecting nominal
issuances as outstanding for all historical periods
in the computation of earnings per share does not
alter that existing responsibility under GAAP.
____________________
1 Whether a security was
issued for nominal consideration should be
determined based on facts and circumstances. The
consideration the entity receives for the issuance
should be compared to the security’s fair value to
determine whether the consideration is nominal.
2 The stock and warrants
encompasse[d] by the prior guidance were those
issuances of common stock at prices below the IPO
price and options or warrants with exercise prices
below the IPO price that were issued within a
one-year period prior to the initial filing of the
registration statement relating to the IPO through
the registration statement’s effective date.
3 The FASB ASC Master
Glossary defines potential common stock as “a
security or other contract that may entitle its
holder to obtain common stock during the reporting
period or after the end of the reporting
period.”
4 As prescribed by FASB
ASC Topic 718, Compensation — Stock
Compensation.
FRM Topic 7
7520.2 Nominal
Issuances [SAB Topic 4D]
-
Nominal issuances of shares are considered in-substance recapitalization transactions. Issuances of shares for which compensation or other expense has been appropriately recorded under ASC 718 ordinarily would not be considered nominal issuances since consideration received for issuance of shares may include goods or services. However, even if goods or services are received, it may still be necessary to compare the consideration received, as accounted for in the financial statements, to the fair value of the shares issued to determine whether the consideration is nominal. Also, issuances of shares in exchange for assets (for example, SAB 48 transactions) would not be considered nominal issuances, unless the fair value of the assets is nominal.
-
In an IPO, and in subsequent filings, nominal issuances of common stock and potential common stock (for example, options and warrants) should be reflected in the calculation of earnings per share for periods prior to their issuance in a manner similar to a stock split or stock dividend for which retroactive treatment is required. [ASC 260-10-55-12]
-
Nominal issuances should be limited to certain issuances to investors or promoters.
SAB Topic 4.D and paragraph 7520.2 of the FRM address the SEC staff’s views on
an SEC registrant’s accounting for nominal issuances. Although this guidance
is for SEC registrants, it would apply to all entities that present EPS.
According to such guidance, as well as that in ASC 260, nominal issuances of
common stock should be included in basic EPS in a manner similar to how a
stock dividend or stock split is included; accordingly, in such
circumstances, all prior periods presented (including any selected financial
data) must be treated retrospectively for EPS purposes (see Section 8.2). A
nominal issuance may also occur in connection with an issuance of potential
common stock, such as a warrant or an option to purchase common stock. When
a nominal issuance is in the form of potential common stock, generally only
diluted EPS would be affected.
8.3.4.2 Determining Whether a Nominal Issuance Has Occurred
To determine whether a nominal issuance of common stock has occurred, an entity should compare (1) the total consideration payable by the party that receives the shares with (2) the fair value of the shares of common stock issued. To determine whether a nominal issuance of potential common stock has occurred, an entity should compare (1) the total consideration payable by the party that receives the instrument with (2) the fair value of the instrument issued.
The total consideration payable by the party that receives the shares or
potential common shares should include the cash amount payable and any other
assets or future services that the holder must render in return for the
shares or potential common shares. That is, the determination of whether an
issuance represents a nominal issuance is based on consideration of a ratio
that consists of a (1) numerator, which comprises any cash received for the
issuance plus the fair value of any other noncash consideration received,
such as goods and services received (whether provided by an employee or
nonemployee service provider), and (2) denominator, which equals the fair
value of the common stock or potential common stock issued. As noted in
paragraph 7520.2 of the FRM, nominal issuances are limited to issuances to
investors or promoters, because when shares of common stock or potential
common stock are issued to employees, compensation cost is recognized under
ASC 718 on the basis of the fair value of the award. Since the consideration
payable equals the fair value of the award, a nominal issuance cannot occur.
If, however, the party that received the award is not a customer and has
never provided (and will not be required to provide in the future) any
substantive goods or services as an employee or nonemployee, and it is
determined that the issuance is not within the scope of ASC 718, a nominal
issuance may have been deemed to have occurred. An entity must use
significant judgment to determine the substance of certain transactions
involving the issuance of common stock or potential common stock.
The determination of whether a nominal issuance has occurred must be based on
the specific facts and circumstances of each issuance; an entity cannot
apply a standard ratio in determining whether an issuance is considered
nominal. While the SEC staff has not specified any numerical thresholds or
rebuttable presumptions related to when a nominal issuance has occurred, the
staff has indicated that it expects the ratio to be very low and that it
would expect a nominal issuance, such as founders’ shares, to be rare.
Nominal issuances are expected to exist when the substance of the
transaction reflects a recapitalization (i.e., a stock split or reverse
stock split). Nominal issuances, as discussed by the SEC staff, have only
occurred before an IPO. However, the substance of any issuance must be
evaluated to determine whether it is appropriate to treat the issuance as a
stock split, reverse stock split, or stock dividend.
The examples below illustrate the determination of whether issuances are nominal.
Example 8-5
Nominal Issuance — Shares and Options
Entity A, which has a calendar year-end, expects to complete an IPO of its common stock on June 1, 20X9. In the three-year period leading up to the IPO, A issued the following shares of common stock and options to purchase common stock:
- In January 20X7, as an inducement to join the entity, A granted its new CEO options to purchase common stock with an exercise price of $1 for each share of common stock purchased. The options cliff vest at the end of the third year of service. As of the grant date, the market price of A’s common stock was $100 per share.
- In April 20X8, A issued an existing investor 3,000 shares of common stock for $1 per share. As of the issuance date, the market price of A’s common stock was $110. This issuance was not consideration in exchange for any goods or services provided (or to be provided) by the investor.
The issuance of stock options to the CEO is not considered a nominal issuance because the ratio of consideration that would be received upon exercise of the stock options (including compensation cost recognized in accordance with ASC 718) to the fair value of the shares of common stock that would be issued upon exercise is at or close to 100 percent. Accordingly, the stock options would not be accounted for retrospectively. Furthermore, the common stock underlying the stock options would not be included in the calculation of basic EPS; however, if the stock options are dilutive, they would be included in the calculation of diluted EPS under the treasury stock method in periods after the grant date.
The April 20X8 share issuance is a nominal issuance because the ratio of
consideration received to the fair value of the
shares of common stock issued is less than 1
percent, or $3,000 ($1 cash paid for the shares ×
3,000 shares) ÷ $330,000 ($110 fair value per share
× 3,000 shares). Therefore, these shares of common
stock should be included in the weighted-average
shares outstanding for basic and diluted EPS for all
prior periods in the same manner as a stock split.
Example 8-6
Nominal Issuance
— Shares
Entity T, a bank, completes its IPO of common stock on April 20, 20X7. Before the IPO, T was a wholly owned subsidiary of M, a federally chartered mutual holding company. Immediately before the IPO, T entered into the following transactions:
- Entity T declared to M a stock dividend consisting of 227 million shares of T’s common stock; M previously owned 1,000 shares of T’s common stock.
- Entity T issued 5 million shares of common stock to a nonconsolidated charitable foundation for $0.01 per share (the “foundation shares”).
In the IPO, T issued 100 million shares of common stock to public subscribers in the offering. Thus, after the IPO, T had 333 million shares of common stock outstanding, which was owned by M (68.5 percent of total), third-party investors in the IPO (30 percent of total), and the charitable foundation (1.5 percent of total).
The issuance of the foundation shares is not a nominal issuance because the total consideration received includes the cash paid by the foundation and a charitable contribution, which equals 100 percent of the fair value of the shares of common stock issued. Entity T should reflect a contribution expense in the period in which the shares were issued (equal to the fair value of the common shares issued less the cash received) and should reflect the shares as outstanding for basic and diluted EPS only from the issuance date.
Retrospective treatment of the stock dividend paid to M, which did not dilute M’s interest in T, is appropriate. However, the issuance of the foundation shares, as well as the issuance of shares of common stock to the public in the IPO, both of which dilute M’s ownership interest in T, should be treated prospectively from the issuance date.
8.4 Accelerated Share Repurchase Agreements
8.4.1 Background
ASC 505-30
Accelerated Share Repurchase Programs
25-5 An accelerated share repurchase program is a combination of transactions that permits an entity to repurchase a targeted number of shares immediately with the final repurchase price of those shares determined by an average market price over a fixed period of time. An accelerated share repurchase program is intended to combine the immediate share retirement benefits of a tender offer with the market impact and pricing benefits of a disciplined daily open market stock repurchase program.
25-6 An entity shall account for such an accelerated share repurchase program as the following two separate transactions:
- As shares of common stock acquired in a treasury stock transaction recorded on the acquisition date
- As a forward contract indexed to its own common stock. Subtopic 815-40 provides guidance on the accounting for contracts that are indexed to an entity’s own common stock.
Example 1 (see paragraph 505-30-55-1) provides an illustration of an accelerated share repurchase program that is addressed by this guidance.
Example 1: Accelerated Share Repurchase Program
55-1 This Example illustrates the guidance in paragraph 505-30-25-5 by identifying the two separate transactions, namely a treasury stock purchase and a forward contract, that are present in what is sometimes described as an accelerated share repurchase program.
55-2 The treasury stock purchase is as follows.
55-3 Investment Banker, an unrelated third party, borrows 1,000,000 shares of Company A common stock from investors, becomes the owner of record of those shares, and sells the shares short to Company A on July 1, 1999, at the fair value of $50 per share. Company A pays $50,000,000 in cash to Investment Banker on July 1, 1999, to settle the purchase transaction. The shares are held in treasury. Company A has legal title to the shares, and no other party has the right to vote those shares.
55-4 The forward contract is as follows.
55-5 Company A simultaneously enters into a forward contract with Investment Banker on 1,000,000 shares of its own common stock. On the October 1, 1999, settlement date, if the volume-weighted average daily market price of Company A’s common stock during the contract period (July 1, 1999, to October 1, 1999) exceeds the $50 initial purchase price (net of a commission fee to Investment Banker), Company A will deliver to Investment Banker cash or shares of common stock (at Company A’s option) equal to the price difference multiplied by 1,000,000. If the volume-weighted average daily market price of Company A’s common stock during the contract period is less than the $50 initial purchase price (net of a commission fee to Investment Banker), Investment Banker will deliver to Company A cash equal to the price difference multiplied by 1,000,000.
55-6 Under the guidance in paragraph 505-30-25-5, an entity would account for this accelerated share repurchase program as two separate transactions:
- As shares of common stock acquired in a treasury stock transaction recorded on the July 1, 1999 acquisition date
- As a forward contract indexed to its own common stock.
55-7 See Example 13 (paragraph 260-10-55-88) for the effect on earnings per share (EPS) for this Example.
ASC 260-10
Example 13: Accelerated Share Repurchase Programs
55-88 Example 1 in Subtopic 505-30 (see paragraph 505-30-55-1) illustrates the accounting for what is sometimes described as an accelerated share repurchase program. In that Example, separate transactions involving a treasury stock purchase and a forward contract are addressed. This Example addresses the EPS consequences of those transactions.
55-89 The treasury stock transaction would result in an immediate reduction of the outstanding shares used to calculate the weighted-average common shares outstanding for both basic and diluted EPS. The effect of the forward contract on diluted EPS would be calculated in accordance with this Subtopic.
In an accelerated share repurchase program, an entity makes an up-front cash
payment (often with the proceeds from the issuance of debt) to repurchase a number of its
own common shares at inception and simultaneously enters into a forward contract to either
issue common shares or receive additional common shares. Under the forward contract, the
entity either (1) pays the counterparty an amount equal to the excess of the
volume-weighted average daily purchase price of the entity’s common shares purchased in
the market by the counterparty over the initial purchase price (net of a commission fee
paid to the counterparty) or (2) receives from the counterparty an amount equal to the
excess of the initial purchase price (net of a commission fee paid to the counterparty)
over the volume-weighted average purchase price of the entity’s common shares purchased in
the market by the counterparty. In certain cases, the settlement of the forward contract
is subject to a cap and a floor price. The entity typically can choose to settle the
forward contract in cash or common stock but in some cases must receive cash when it is in
a gain position.
8.4.2 EPS Accounting
As noted in ASC 505-30-25-6, an accelerated share repurchase program is
accounted for as two separate transactions. The table below outlines how the EPS
accounting related to the two separate transactions is affected when the forward contract
is classified within stockholders’ equity. Note that the forward contract component can
only be dilutive to EPS under the treasury stock method if the entity is in the position
of issuing, as opposed to receiving, common shares.
Table 8-2
Transaction | EPS Accounting |
---|---|
Treasury stock transaction | The shares of common stock repurchased reduce the number of shares outstanding in the computation of the weighted-average common shares outstanding for basic and diluted EPS. The shares are considered repurchased as of the acquisition date. If an entity receives shares of common stock on multiple dates, the shares of common stock should not be reduced in the calculation of the weighted-average shares of common stock outstanding before their receipt. |
Forward contract | Basic EPS — If the forward contract meets the definition of a participating security, the two-class method of EPS must be applied. See Section 5.3.3.5 for a discussion of when a forward contract meets the definition of a participating security. If the forward contract does not meet the definition of a participating security and is equity-classified, it will have no impact on basic EPS before settlement. On settlement, basic EPS will be affected by the additional shares of common stock issued or received (on a weighted-average basis). Diluted EPS — The entity applies the treasury stock method to determine
the dilution (or if the forward contract meets the definition of a
participating security, the more dilutive of the treasury stock method or
two-class method of calculating diluted EPS).
ASC 260-10-45-21A states, in part, that if “the number of
shares to be included in the diluted EPS denominator is affected by the
entity’s share price . . . [i]n applying . . . the treasury stock method . . .
, the average market price shall be used for purposes of calculating the
denominator for diluted EPS . . . , except for contingently issuable shares
within the scope of the guidance in paragraphs 260-10-45-48 through 45-57.” In
accordance with this guidance, an entity must determine whether it believes
that the guidance on contingently issuable shares in ASC 260-10-45-52 applies
to determining the impact of the forward contract on diluted EPS. Because it
is unclear whether that method should be applied to this contract, it is
acceptable for an entity to determine the impact of the forward contract on
diluted EPS by applying either (1) the guidance on variable denominators in
ASC 260-10-45-21A or (2) the guidance on contingently issuable shares in ASC
260-10-45-52.3 The approach selected should be applied consistently to all similar
contracts.
The ability to choose between these two approaches is
consistent with our informal discussions with the FASB staff. In these
discussions, the staff noted that the FASB did not intend for ASU 2020-06 to
change when entities apply the contingently issuable share method to calculate
diluted EPS. The staff also acknowledged that because the current guidance in
ASC 260 is unclear on this matter, there may be diversity in practice
regarding when the contingently issuable share method is applied.
Note that even if the entity has the option of settling the
payment in cash or shares, share settlement must be applied in the calculation
of diluted EPS in accordance with ASC 260-10-45-45 (see Section 4.7). In some situations, an accelerated share repurchase may be structured in such a way that the entity can only receive additional shares of common stock upon settlement of the forward contract for no additional consideration. In such circumstances, the receipt of additional shares of common stock would be antidilutive and therefore no adjustments may be made in the computation of diluted EPS. That is, the shares of common stock potentially receivable under the forward contract should only reduce the denominator in the EPS calculations (on a weighted basis) when and if received and should not be included in diluted EPS before receipt because of the antidilutive impact. |
If an entity classifies the forward contract as an asset or liability, the
accounting for basic EPS will be similar to that for an equity-classified forward contract
(i.e., the two-class method will be applied if the forward contract is a participating
security). In calculating diluted EPS, the entity must consider whether the forward
contract must be settled in cash or whether it permits the entity or the counterparty to
choose to settle any obligation of the entity under the forward contract in cash. The
accounting for diluted EPS, which depends on this consideration, is as follows:
-
Forward contract must be settled in cash — The forward contract is classified as an asset or liability and remeasured to fair value in each period, with changes in fair value reported in earnings. Since the settlement of the contract will not result in any exchange of common shares, no further adjustment is needed in the calculation of diluted EPS.
-
Forward contract allows the entity to settle its obligation in cash or shares — As discussed in Section 4.7, when an entity is permitted to choose whether to settle a contract in cash or common shares, it is presumed that the contract will be settled in common shares. This presumption may not be overcome. Therefore, the impact on the denominator in the calculation of diluted EPS is the same as that when the forward contract is classified in equity (see above). However, the entity must also adjust the numerator to reverse any mark-to-market adjustment recognized in earnings during the period. The entity must consider that adjustment, along with the incremental shares included in the denominator, to determine whether the effect is dilutive to EPS. See Section 4.7.3 for further discussion of contracts that may be settled in cash or shares that are classified as assets or liabilities for accounting purposes.
-
Forward contract allows the counterparty to receive cash or shares — If the counterparty can elect to receive cash or shares from the entity as payment of the entity’s obligation, the forward contract is classified as an asset or liability and measured at fair value through earnings. In such circumstances, the entity must assume share settlement of the contract if the effect is dilutive. In applying the treasury stock method, the entity must adjust the numerator to reverse the mark-to-market impact during the financial reporting period with respect to recording the forward contract as an asset or liability. This accounting for diluted EPS is similar to that employed when the entity can choose to settle its obligation in cash or shares. See Section 4.7.3 for further discussion of contracts that may be settled in cash or shares that are classified as assets or liabilities for accounting purposes.
Footnotes
3
Under this approach, an entity would use the
end-of-period stock price to determine whether it would issue or receive
consideration under the forward contract. If the entity would be in the
position of issuing shares, it should include the shares that it would be
required to deliver to the counterparty in the denominator of the
calculation of diluted EPS. Those shares would be considered outstanding
for diluted EPS for the entire period in which the forward contract was
outstanding during the reporting period. (Note that an average stock price
may be used in lieu of the end-of-period stock price under this approach
if the settlement is based on a weighted-average stock price; for example,
if the settlement is based on the weighted-average closing stock price
over the 20 trading days ending 3 trading days before settlement, in lieu
of using the end-of-period stock price, the entity would use the average
closing price of its common stock for the 20 trading days ending 3 trading
days immediately preceding the end of the reporting period).
8.5 Own-Share Lending
8.5.1 Background
ASC 470-20
Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance or Other Financing
05-12A An entity for which the cost to an investment banking firm (investment bank) or third-party investors (investors) of borrowing its shares is prohibitive (for example, due to a lack of liquidity or extensive open short positions in the shares) may enter into share-lending arrangements that are executed separately but in connection with a convertible debt offering. Although the convertible debt instrument is ultimately sold to investors, the share-lending arrangement is an agreement between the entity (share lender) and an investment bank (share borrower) and is intended to facilitate the ability of the investors to hedge the conversion option in the entity’s convertible debt.
05-12B The terms of a share-lending arrangement require the entity to issue shares (loaned shares) to the investment bank in exchange for a nominal loan processing fee. Although the loaned shares are legally outstanding, the nominal loan processing fee is typically equal to the par value of the common stock, which is significantly less than the fair value of the loaned shares or the share-lending arrangement. Generally, upon maturity or conversion of the convertible debt, the investment bank is required to return the loaned shares to the entity for no additional consideration.
05-12C Other terms of a share-lending arrangement typically require the investment bank to reimburse the entity for any dividends paid on the loaned shares. Typically, the arrangement precludes the investment bank from voting on any matters submitted to a vote of the entity’s shareholders to the extent the investment bank is the owner of the shares.
Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance
45-2A Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. If dividends on the loaned shares are not reimbursed to the entity, any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to the loaned shares shall be deducted in computing income available to common shareholders, in a manner consistent with the two-class method in paragraph 260-10-45-60B.
ASC 470-20 provides recognition and measurement guidance on the issuer’s
accounting for equity-classified share-lending arrangements that are executed in
contemplation of a convertible debt issuance or other financing. Therefore, for
loaned share transactions, an entity must first evaluate whether the lending
arrangement meets the conditions for equity classification in ASC 480-10 and ASC
815-40. The example below illustrates an own-share lending arrangement entered
into with a convertible debt offering.
Example 8-7
Share-Lending Arrangement Entered Into With Convertible Debt Offering
Entity A is in the process of issuing convertible debt. Before they agree to buy the convertible debt, certain prospective investors would like to ensure that they are able to economically hedge their exposure to A’s share price risk associated with the conversion option embedded in the debt. Accordingly, they seek to enter into derivative contracts on the underlying shares with Bank B (such as options, forwards, or total return swaps) that offset the “long” position in A’s share price risk that would result from an investment in the convertible debt. To economically hedge its exposure from writing such derivatives, B in turn seeks to borrow the underlying shares. By borrowing the shares, B can sell them short in the market to offset its “long” position in A’s share price risk that would be created by its derivative contracts with the investors.
Because a sufficient number of A’s underlying shares is not readily available to market participants (or the lending price is too high), B borrows the underlying shares by entering into a share-lending arrangement directly with A. The terms of the share-lending arrangement require B to pay a nominal processing fee to A (e.g., the par value of the shares) that is significantly less than the fair value of the share-lending arrangement. Entity A is motivated to enter into the agreement because the pricing and successful completion of the convertible debt offering depend on the investors’ ability to enter into derivative contracts to hedge their equity price exposure, which in turn depends on B’s ability to borrow the shares from A. During the period the shares are on “loan,” the shares are legally outstanding and the holder is legally entitled to dividends paid on the shares, although it must reimburse A for any dividends paid on the loaned shares. Upon conversion or maturity of the convertible debt, B must physically return the loaned shares to A for no consideration. If B defaults in returning the loaned shares, A is contractually entitled to a cash payment equal to the fair value of the loaned shares.
If an own-share lending arrangement meets the conditions for equity
classification, the entity is required to recognize the lending arrangement at
fair value in APIC, with an offsetting entry recognized as a debt issuance cost
on the convertible debt issued in conjunction with the arrangement (i.e., a
debit for the convertible debt liability and a credit for the APIC). The entity
subsequently accounts for the convertible debt, including the discount created
by the issuance costs recognized in accordance with other U.S. GAAP, and does
not remeasure the amount initially recognized in equity as long as (1) the
share-lending arrangement continues to qualify for equity treatment and (2) it
is not probable that the counterparty to the share-lending arrangement will
default in returning the loaned shares (or an equivalent amount of
consideration). If it becomes probable that the counterparty to the
share-lending arrangement will default in returning the loaned shares (or an
equivalent amount of consideration), the issuer must recognize an expense equal
to the fair value of the unreturned shares, adjusted for the fair value of any
probable recoveries. The offsetting entry for the expense is to equity (i.e., a
debit for the loss and a credit for the APIC). The amount of the loss (i.e., the
fair value of the unreturned shares adjusted for probable recoveries) is
remeasured in each period for changes in the fair value of the unreturned shares
until the consideration payable becomes fixed. The issuer recognizes changes in
the amount of the loss in earnings, with an offset to APIC.
8.5.2 EPS Accounting
8.5.2.1 Equity-Classified Own-Share Lending Arrangements
ASC 470-20
Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance
45-2A Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. If dividends on the loaned shares are not reimbursed to the entity, any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to the loaned shares shall be deducted in computing income available to common shareholders, in a manner consistent with the two-class method in paragraph 260-10-45-60B.
Under ASC 470-20, loaned shares are excluded from the denominator of both basic
and diluted EPS unless the counterparty to a share-lending arrangement
defaults on its obligation to return the loaned shares (or an equivalent
amount of consideration). If the counterparty defaults, the loaned shares
are included in both basic and diluted EPS.
As discussed above, the threshold for including the loaned
shares in the denominator in the calculations of basic and diluted EPS is
counterparty default. This threshold differs from the requirement in ASC
470-20-35-11A for the issuer to recognize an expense equal to the then fair
value of the unreturned shares, net of the fair value of recoveries, when it
becomes probable that the counterparty to the share-lending arrangement will
default. These threshold recognition differences create a difference between
the timing of recognition in the numerator of the EPS calculation (i.e., the
expense for probable losses) and that in the denominator of the EPS
calculation (i.e., the shares when default actually occurs). However, this
timing difference can also exist for contingently issuable shares.
In practice, own-share lending arrangements generally require the counterparty to reimburse the issuer for any dividends paid on the loaned shares. If the counterparty does not reimburse the issuer for any dividends paid on the loaned shares, the share-lending arrangement is treated as a participating security and the two-class method of EPS must be applied.
8.5.2.2 Liability-Classified Own-Share Lending Arrangements
ASC 470-20 does not provide any recognition, measurement, or EPS accounting
guidance related to situations in which a share-lending arrangement is
classified as a liability by the issuer of the shares. Therefore, the EPS
accounting will depend on the reason the contract is classified as a
liability. If the issuing entity classifies an own-share lending arrangement
as a liability solely because the contract is not considered indexed to the
issuing entity’s stock, it is generally appropriate for the guidance on
basic and diluted EPS relevant to equity-classified own-share lending
arrangements to be applied to the denominator. The EPS accounting when the
contract is liability-classified for other reasons will depend on the facts
and circumstances. With respect to diluted EPS, the guidance on contracts
that may be settled in cash or stock may be relevant. See Section 4.7 for more
information.
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
Transactions.
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.
8.7 Discontinued Operations
8.7.1 EPS for Discontinued Operations
ASC 205-20 provides accounting and presentation guidance related to discontinued operations. According to ASC 260-10-45-3, an entity that reports a discontinued operation must present basic and diluted EPS for the discontinued-operations line item “either on the face of the income statement or in the notes to the financial statements.” This requirement is in addition to the requirement to present basic and diluted EPS for income (loss) from continuing operations and net income (loss). See Section 9.1.5 for additional discussion of how an entity should present and disclose EPS when it reports a discontinued operation.
8.7.1.1 Control Number for Diluted EPS
ASC 260-10
No Antidilution
45-20 The control number for determining whether including potential common shares in the diluted EPS computation would be antidilutive should be income from continuing operations (or a similar line item above net income if it appears on the income statement). As a result, if there is a loss from continuing operations, diluted EPS would be computed in the same manner as basic EPS is computed, even if an entity has net income after adjusting for a discontinued operation. Similarly, if an entity has income from continuing operations but its preferred dividend adjustment made in computing income available to common stockholders in accordance with paragraph 260-10-45-11 results in a loss from continuing operations available to common stockholders, diluted EPS would be computed in the same manner as basic EPS.
As noted in ASC 260-10-45-20, the control number in the calculation of diluted
EPS is income from continuing operations. Therefore, when an entity has a
discontinued operation, the income (loss) from discontinued operations, net
of tax, will be excluded from the determination of whether potential common
stock is dilutive in the calculation of diluted EPS. See Section 8.7.2.2 for
discussion of the control number when an entity with an NCI reports
discontinued operations. See also Section 4.1.2 for general discussion
of the concepts of antidilution and the control number.
8.7.2 NCI in Discontinued Operation
8.7.2.1 Income Statement Presentation
When an entity has an NCI in a discontinued operation, the amount of income
(loss) from discontinued operations, net of tax,
that is reported on the face of the income
statement includes amounts attributable to
the NCI in the discontinued operation in
accordance with ASC 205-20-45-3. Below
consolidated net income (loss), the entity
presents income (loss) attributable to NCI, net of
tax, which includes amounts attributable to
both income (loss) from continuing operations and
discontinued operations. These amounts are
deducted from consolidated net income (loss) to
arrive at net income (loss) attributable to the
parent. An entity must separately disclose income
(loss) from discontinued operations attributable
to the parent in accordance with ASC 810-10-50-1A.
Example 2 in ASC 810-10 includes an example illustrating the income statement an
entity may provide when it reports a discontinued
operation and has an NCI.
ASC 810-10
55-4J This consolidated statement of income illustrates the requirements in paragraph 810-10-50-1A that the amounts of consolidated net income and the net income attributable to Entity ABC and the noncontrolling interest be presented separately on the face of the consolidated income statement. It also illustrates the requirement in paragraph 810-10-50-1A(b) that the amounts of income from continuing operations and discontinued operations attributable to Entity ABC should be disclosed.
In this example, the NCI pertains to both continuing operations and discontinued
operations. The presentation would be similar if
the NCI pertained only to continuing operations or
only to discontinued operations.
8.7.2.2 EPS Accounting
Under ASC 260, the numerator in the calculation of EPS (i.e., income available
to common stockholders) excludes income
(loss) attributable to NCIs. Similarly, in the
calculation of basic and diluted EPS amounts
pertaining to a discontinued operation, the
numerator excludes income (loss)
attributable to NCIs. In other words, for both
calculations, the numerator is calculated on the
basis of income (loss) attributable to the parent,
net of tax. The control number for both
calculations will be income (loss) from continuing
operations, net of tax, attributable to the
parent. Thus, the control number in the
calculation of basic and diluted EPS for
discontinued operations excludes both (1)
income (loss) from continuing operations
attributable to NCI, net of tax, and (2) income
(loss) from discontinued operations, net of tax
(including amounts attributable to both the parent
and any NCI in the discontinued operation).
The example below illustrates the EPS accounting and presentation related to a
situation in which an entity reports a
discontinued operation and there is an NCI in the
discontinued operation. See Section
8.8 for additional discussion of the
calculation of basic and diluted EPS for
less-than-wholly-owned subsidiaries.
Example 8-19
NCI in a Discontinued Operation
Assume the following:
- Company T is a holding company that owns 85 percent of Company U and 75 percent of Company V.
- Company T’s operations consist solely of its investments in its consolidated subsidiaries U and V.
- Company T accounts for the 15 percent investment in U owned by third parties as an NCI.
- Company T accounts for the 25 percent investment in V owned by third parties as an NCI.
- In 20X1, T sells its 85 percent interest in U, which qualifies as a discontinued operation.
- Income from continuing operations for 20X1 is $2,500 before tax and $2,000 after tax. The NCI’s share of income from continuing operations, net of tax, for 20X1 is $500 (i.e., $2,000 × 25%).
- Income from discontinued operations for 20X1 is $400 after tax. The NCI’s share of income from discontinued operations, net of tax, for 20X1 is $60 (i.e., $400 × 15%).
- The weighted-average common shares outstanding during 20X1 are 2,000.
- The weighted-average potential common shares outstanding during 20X1 are 500.
Company T’s income statement presentation is as follows:
Company T’s calculation of basic and diluted EPS is as follows:
8.7.2.2.1 Preferred Stock Issued by Subsidiary That Represents a Discontinued Operation
Section 8.8.2.3 discusses the treatment of dividends on preferred stock issued by a subsidiary when the subsidiary is classified as a discontinued operation in the consolidated financial statements of its parent.
8.8 Securities of Subsidiaries and Equity Method Investees
8.8.1 General
8.8.1.1 EPS Accounting
ASC 260-10
Income Available to Common Stockholders and Preferred Dividends
45-11A For purposes of
computing EPS in consolidated financial statements
(both basic and diluted), if one or more
less-than-wholly-owned subsidiaries are included in
the consolidated group, income from continuing
operations and net income shall exclude the income
attributable to the noncontrolling interest in
subsidiaries. Example 7 (see paragraph 260-10-55-64)
provides an example of calculating EPS when there is
a noncontrolling interest in a subsidiary in the
consolidated group.
Securities of Subsidiaries
55-20 The effect on consolidated EPS of options, warrants, and convertible securities issued by a subsidiary depends on whether the securities issued by the subsidiary enable their holders to obtain common stock of the subsidiary or common stock of the parent entity. The following general guidelines shall be used for computing consolidated diluted EPS by entities with subsidiaries that have issued common stock or potential common shares to parties other than the parent entity
- Securities issued by a subsidiary that enable their holders to obtain the subsidiary’s common stock shall be included in computing the subsidiary’s EPS data. Those per-share earnings of the subsidiary shall then be included in the consolidated EPS computations based on the consolidated group’s holding of the subsidiary’s securities. Example 7 (see paragraph 260-10-55-64) illustrates that provision.
- Securities of a subsidiary that are convertible into its parent entity’s common stock shall be considered among the potential common shares of the parent entity for the purpose of computing consolidated diluted EPS. Likewise, a subsidiary’s options or warrants to purchase common stock of the parent entity shall be considered among the potential common shares of the parent entity in computing consolidated diluted EPS. Example 7 (see paragraph 260-10-55-64) illustrates that provision.
55-21 The preceding provisions also apply to investments in common stock of corporate joint ventures and investee companies accounted for under the equity method.
55-22 The if-converted method shall be used in determining the EPS impact of securities issued by a parent entity that are convertible into common stock of a subsidiary or an investee entity accounted for under the equity method. That is, the securities shall be assumed to be converted and the numerator (income available to common stockholders) adjusted as necessary in accordance with the provisions in paragraph 260-10-45-40(a) through (b). In addition to those adjustments, the numerator shall be adjusted appropriately for any change in the income recorded by the parent (such as dividend income or equity method income) due to the increase in the number of common shares of the subsidiary or equity method investee outstanding as a result of the assumed conversion. The denominator of the diluted EPS computation would not be affected because the number of shares of parent entity common stock outstanding would not change upon assumed conversion.
When an entity has an NCI in a consolidated subsidiary, regardless of whether
the subsidiary reports EPS, the entity must calculate basic and diluted EPS
at the subsidiary level to determine income from continuing operations and
net income attributable to the parent in the calculation of basic and
diluted EPS of the consolidated group to be presented in the consolidated
financial statements. In other words, EPS amounts are calculated at the
subsidiary level and the parent’s portion of the subsidiary’s EPS is
included in EPS of the consolidated group. The parent’s portion is
determined by multiplying the number of shares of the subsidiary’s common
stock owned by the parent by the subsidiary’s amounts of basic and diluted
EPS. The product of these two amounts is included in the numerator in the
parent’s calculation of the consolidated group’s basic and diluted EPS.
When an entity has an equity method investment, in accordance with ASC
260-10-55-21, the “flow-through” approach applicable to entities with NCIs
is used to calculate basic and diluted EPS unless the entity has elected the
fair value option for the equity method investee. Thus, an entity with an
equity method investee must consider the dilutive effect of the investee’s
potential common shares in calculating its diluted EPS. As with the
accounting for diluted EPS that applies to NCIs, the dilutive effect of the
equity method investee’s potential common shares will affect the numerator
in the investor’s calculation of diluted EPS. That is, the numerator will
include the investee’s diluted EPS multiplied by the number of the
investee’s shares owned by the entity. As a result, a reduction of the
investee’s diluted EPS that is attributable to the investee’s potential
common shares will reduce the amount included in the numerator in the
investor’s calculation of diluted EPS.
If an entity accounts for an equity method investee at fair value through
earnings, the flow-through approach in ASC 260-10-55-21 may not be
appropriate since the investor does not use the equity method of accounting
to recognize the investee’s earnings and losses. In this circumstance, it is
acceptable for the investor not to apply ASC 260-10-55-21. That is, any
dilution arising from the equity method investee would be reflected in the
mark-to-market adjustment resulting from the periodic change in the
investment’s fair value recognized in net income (i.e., the entity does not
need to make any additional adjustments to calculate diluted EPS). This
approach is consistent with the accounting for contracts that are settled in
cash and recognized at fair value through earnings. If, however, the
investor applies ASC 260-10-55-21, the entity should also consider the need
for an additional numerator adjustment that reflects the difference between
the results of the equity method of accounting and those of fair value
accounting. See Section
4.7 for further discussion of the guidance applicable to
contracts that may be settled in stock or cash.
Connecting the Dots
Under ASC 810, an entity with an NCI in a consolidated subsidiary must report
net income on the face of the income statement before any
allocations to the NCI. However, the entity only reports EPS amounts
attributable to the parent. That is, income or loss of a subsidiary
that is attributable to the NCI is excluded from all EPS amounts
that are presented for the consolidated group. References herein to
“EPS of the consolidated group” mean EPS calculations presented in
the consolidated financial statements that include only the parent’s
portion of (1) income or loss attributable to NCIs and (2) earnings
or losses of an equity method investee.
ASC 260-10-55-20 through 55-22 contain guidance addressing how potential common
stock is treated in the parent’s calculation of diluted EPS of the
consolidated group when the parent has an investment in a
less-than-wholly-owned consolidated subsidiary. In accordance with this
guidance, the impact on the calculation of the consolidated group’s EPS will
depend on whether the potential common stock represents potential shares of
the parent or the subsidiary. The table below summarizes the impact of
potential common stock on the diluted EPS of the consolidated group when the
potential common stock was not issued in a share-based payment arrangement.
See Section
7.1.8 for more information about the accounting for
share-based payment awards.
Connecting the Dots
The calculation of the diluted EPS of a consolidated group that
includes an NCI must conform to the antidilution and sequencing
requirements of ASC 260 (see Section
4.1.2). In accordance with that guidance, the control
number is based on the subsidiary’s income or loss. Therefore, if
the subsidiary’s control number is a loss, the inclusion of
potential common shares in diluted EPS would be antidilutive.
In addition, antidilution of the parent’s diluted EPS would occur if
(1) the only potential common shares of the subsidiary are options
held by the parent that allow it to increase its ownership or (2)
the parent holds more options to purchase the subsidiary’s common
stock than third-party investors do. Because only potential common
shares that are dilutive may be included in the calculation of
diluted EPS, the parent entity should ensure that its diluted EPS
complies with the antidilution guidance in ASC 260.
Table 8-6
Potential Common Stock | |||
---|---|---|---|
Type | Issued by | Settled in Shares of | Impact on Diluted EPS of Consolidated Group14 |
Option on common stock15 | Subsidiary | Subsidiary | Numerator — The potential common stock reduces the numerator in the parent’s calculation of diluted EPS for the consolidated group. The impact on the numerator is determined on the basis of the subsidiary’s calculation of diluted EPS by using the treasury stock method. The parent uses the subsidiary’s diluted EPS to calculate its share of the subsidiary’s income for purposes of diluted EPS of the consolidated group.
Denominator — The denominator in the parent’s calculation of diluted EPS of the consolidated group is not affected because the assumed exercise has no impact on the number of shares of the parent’s common stock outstanding. |
Parent | Numerator — The numerator in the parent’s calculation of diluted EPS of
the consolidated group is not affected because the
number of shares of the subsidiary’s common stock
outstanding would not change upon assumed exercise.
The only exception would be a situation in which the
subsidiary accounts for the option as a liability
instrument in its stand-alone financial statements.
In that circumstance, the numerator in the parent’s
calculation of diluted EPS of the consolidated group
must be adjusted to reverse the impact that the
mark-to-market adjustment in the subsidiary’s
stand-alone financial statements has on the income
of the subsidiary allocated to the parent in
accordance with the guidance in ASC 260 on contracts
that may be settled in cash or stock. Denominator — The potential common stock is included with other potential
common stock of the parent in the parent’s
calculation of diluted EPS of the consolidated
group. While the proceeds upon assumed exercise will
be retained by the subsidiary, it is generally
acceptable to assume that the subsidiary would use
all of the proceeds to repurchase the parent’s
common stock under the treasury stock method. This
assumption is acceptable since consolidation is
consistent with the concept of a single economic
entity and the subsidiary will reflect the receipt
of proceeds in its equity. | ||
Parent | Subsidiary | Numerator — The potential common stock reduces the numerator in the
parent’s calculation of diluted EPS of the
consolidated group. Under ASC 810-10-45-17A, the
initial fair value of the option is recognized in
the parent’s consolidated financial statements as an
NCI. However, since the option was issued by the
parent, it will generally not be recognized in the
subsidiary’s separate financial statements. As a
result, the subsidiary’s potential common stock may
not be reflected in its calculation of diluted EPS.
Therefore, the parent would need to apply the
treasury stock method to determine the reduction in
the numerator in the parent’s calculation of diluted
EPS of the consolidated group. That is, the
potential common stock affects the calculation of
diluted EPS of the consolidated group because the
subsidiary’s income would have been allocated to the
parent and NCI differently if the option was
exercised. While the proceeds upon assumed exercise
will be retained by the parent and will result in an
entry to reclassify amounts from NCI to parent
equity in accordance with ASC 810-10-45-23, it is
acceptable to assume that the parent would use all
of the proceeds to repurchase the subsidiary’s
common stock under the treasury stock method. This
assumption is acceptable since consolidation is
consistent with the concept of a single economic
entity and the parent will reflect the receipt of
proceeds in its equity. Denominator — The denominator in the parent’s calculation of diluted EPS of the consolidated group is not affected because the assumed exercise has no impact on the number of shares of the parent’s common stock outstanding. | |
Convertible debt16 |
Subsidiary
| Subsidiary | Numerator — The potential common stock reduces the numerator in the parent’s calculation of diluted EPS of the consolidated group. The impact on the numerator is determined on the basis of the subsidiary’s calculation of diluted EPS by using the if-converted method. The parent uses the subsidiary’s diluted EPS to calculate its share of the subsidiary’s income for purposes of diluted EPS of the consolidated group.
Denominator — The denominator in the parent’s calculation of diluted EPS of the consolidated group is not affected because the assumed conversion has no impact on the number of shares of the parent’s common stock outstanding. |
Subsidiary
| Parent | Numerator — The parent should apply the if-converted method to calculate
diluted EPS of the consolidated group. In the
parent’s application of the if-converted method, the
numerator must be adjusted to reverse interest
expense and the related income tax effect in
accordance with ASC 260-10-45-40(b). The impact of
that adjustment must be allocated between the parent
and the NCI. The numerator in the parent’s calculation of diluted EPS of the consolidated group is otherwise not affected because the number of shares of the subsidiary’s common stock outstanding would not change upon assumed conversion. The only exception is if the subsidiary accounted for the embedded conversion option as a derivative liability instrument in its stand-alone financial statements. In that circumstance, the numerator in the parent’s calculation of diluted EPS of the consolidated group must be adjusted to reverse the impact that the mark-to-market adjustment in the subsidiary’s stand-alone financial statements had on the subsidiary’s income allocated to the parent in accordance with the guidance in ASC 260 on contracts that may be settled in cash or stock.
Denominator — The potential common stock is included with other potential common stock of the parent in the parent’s calculation of diluted EPS of the consolidated group by using the if-converted method. | |
Parent | Subsidiary | Numerator — The potential common stock reduces the numerator in the parent’s calculation of diluted EPS of the consolidated group. The impact on the numerator is determined on the basis of the calculation of diluted EPS of the consolidated group by using the if-converted method. The parent should apply the if-converted method as follows:
Denominator — The denominator in the parent’s calculation of diluted EPS of the consolidated group is not affected because the assumed conversion has no impact on the number of shares of the parent’s common stock outstanding. |
ASC 260-10-55-20 through 55-22 are also relevant for equity
method investees. For equity method investments, the investor must consider
the potential common stock of the equity method investee when computing
diluted EPS.
8.8.1.2 Examples
ASC 260-10
Example 7: Securities of a Subsidiary — Computation of Basic and Diluted EPS
55-64 This Example illustrates the EPS computations for a subsidiary’s securities that enable their holders to obtain the subsidiary’s common stock based on the provisions in paragraph 260-10-55-20. The facts assumed are as follows:
55-65 Parent Entity:
- Net income was $10,000 (excluding any earnings of or dividends paid by the subsidiary).
- 10,000 shares of common stock were outstanding; the parent entity had not issued any other securities.
- The parent entity owned 900 common shares of a domestic subsidiary entity.
- The parent entity owned 40 warrants issued by the subsidiary.
- The parent entity owned 100 shares of convertible preferred stock issued by the subsidiary.
55-66 Subsidiary Entity:
- Net income was $3,600.
- 1,000 shares of common stock were outstanding.
- Warrants exercisable to purchase 200 shares of its common stock at $10 per share (assume $20 average market price for common stock) were outstanding.
- 200 shares of convertible preferred stock were outstanding. Each share is convertible into two shares of common stock.
- The convertible preferred stock paid a dividend of $1.50 per share.
- No interentity eliminations or adjustments were necessary except for dividends.
- Income taxes have been ignored for simplicity.
55-67 The following table illustrates subsidiary’s EPS.
In the above example, the subsidiary’s basic and diluted EPS must be calculated because the parent’s portion of the subsidiary’s income on a diluted basis is less than the parent’s portion before the consideration of the subsidiary’s potential common stock.
The example below illustrates the calculation of basic and diluted EPS for an
UP-C structure.
Example 8-20
Diluted EPS of UP-C Structure
Company P is a publicly traded holding company that was established only to own
an equity interest in Company O, an LLC that owns
and operates a portfolio of investment properties.
In practice, this type of ownership structure is
often called an “UP-C” structure. In such a
structure, the parent (P in this example) is
typically referred to as “PubCo” while the operating
subsidiary (O in this example) is also known as
“OpCo.”
Company O’s equity capital consists of Class A units and Class B units. These
units have the same rights to distributions of cash
flows, regardless of whether they are periodic or
occur upon liquidation. Company P owns all of the
Class A units and therefore has control of and
consolidates O. The Class B units are owned by
third-party investors and represent an NCI in P’s
consolidated financial statements. The holders of
the Class B units may exchange their units on a 1:1
basis for publicly traded common shares of P. At all
times, P must own one Class A unit for each publicly
traded common share outstanding.
Assume the following as of and for the year ended December 31, 20X1:
- Company P has 1 million outstanding common shares.
- Company O has 1 million outstanding Class A units (all owned by P) and 1 million Class B units (all owned by third parties).
- Company O’s net income is $100 million.
- No dividends are paid (note that this assumption is made for simplicity since, in these types of structures, dividends are generally declared and paid).
For P’s consolidated financial statements, basic EPS should be calculated in accordance with the guidance in Section 8.8.1.1. That calculation is as follows:
Basic EPS of O
Basic EPS of P
Diluted EPS should be calculated on the basis of the more dilutive of the following two calculations:
- Company P’s portion of O’s diluted EPS in accordance with Section 8.8.1.1.
- The if-converted method, for which conversion of the Class B units into P’s common shares is assumed. (Note that in applying the if-converted method, P must adjust the numerator to take into account the earnings of O that were allocated to the NCI and would have been allocated to P if all Class B units had been converted into P’s common shares. See Section 4.4 for further discussion of the if-converted method.)
Since there are no potential common shares of P or O (a simplistic assumption
that would not typically be true), the calculations
of basic and diluted EPS in accordance with
Section
8.8.1.1 are the same. Under the
if-converted method, it is assumed that (1) all
Class B units are converted into common shares of P
and (2) the earnings allocated to the Class B units
are attributable to P because, after the conversion
of Class B units into P’s common shares, P owns all
of the equity of O. The calculation under the
if-converted method is as follows:
As illustrated above, the amounts of diluted EPS under the two calculations are
the same. On the basis of the typical terms of UP-C
structures, which require the parent company (P in
this example) to own one unit of the subsidiary
operating company (O in this example) for each
common share outstanding and provides for a 1:1
conversion rate of operating company units into
parent shares, the two calculations will generally
yield the same reported diluted EPS of the parent.
However, the EPS accounting is more complex when
there are potential common shares of the parent
company or subsidiary operating company.
Further assume the following:
- On January 1, 20X1, P grants 100,000 nonvested common shares to employees. These shares cliff vest at the end of two years. The grant-date fair-value-based measure of these shares is $20 per share, which is also the average share price of P’s common stock for 20X1. These nonvested shares are not participating securities.
- The compensation cost recognized during 20X1 in connection with the nonvested common shares was $1,000,000 (i.e., 100,000 × $20 ÷ 2 = $1,000,000).
- Under the treasury stock method, the 100,000 nonvested common shares produce 25,000 incremental shares to be included in diluted EPS. (Note that the only proceeds under the treasury stock method are the average unrecognized compensation cost, which is $1,500,000. This amount purchases 75,000 shares at an average share price of $20 per share.)
In accordance with the governance documents that require P to always own one unit in O for each common share outstanding, when the nonvested common shares vest, an equivalent number of O’s Class A units will be issued to P. Thus, in applying the treasury stock method, in addition to the 25,000 incremental shares that are included in the denominator, P must take into account the additional Class A units in O that will be owned when those nonvested common shares have vested. Such additional Class A units would change the allocation of O’s net income to the Class A and Class B units. That allocation change is as follows:
Company P’s calculation of diluted EPS under the treasury stock method is as follows:
Note that when the if-converted method is applied, diluted EPS is $48.88, as calculated below.
*
Note that there is no adjustment made to add
back or reverse compensation cost. This amount is
merely showing the compensation cost that was not
included in the previous example.
Diluted EPS under the if-converted method is antidilutive compared with that under the treasury stock method; therefore, P would report diluted EPS of $48.41.
Note that the same concepts in this example apply when share-based payment awards are issued by a subsidiary and those shares are exchangeable into shares of the parent. In such circumstances, the diluted EPS of the consolidated group should be calculated on the basis of the more dilutive of the following two calculations:
- The treasury stock method, under the assumption that the incremental common shares of the subsidiary are not exchanged into the parent’s common shares. As a result, the amount of the subsidiary’s net income that is allocated to the parent entity is reduced (i.e., a reduction of the numerator in the calculation of diluted EPS for the consolidated group).
- The if-converted method, under the assumption that the incremental common shares of the subsidiary are exchanged into common shares of the parent entity. As a result, the number of shares of the parent entity increases (i.e., an increase of the denominator in the calculation of diluted EPS for the consolidated group).
8.8.2 Dividends on Preferred Stock
8.8.2.1 Preferred Stock Issued by Subsidiary to Third Parties
A subsidiary may have preferred stock that it issues to third-party investors.
If the preferred stock is classified as an equity instrument, it meets the
definition of an NCI. In accordance with ASC 260-10-45-11, dividends on
preferred stock reduce income available to common stockholders. Therefore,
dividends on preferred stock of a consolidated subsidiary will reduce income
available to the parent’s common stockholders. The impact that dividends on
the subsidiary’s preferred stock will have on the parent’s basic and diluted
EPS depends on whether the subsidiary’s common stock is also owned by
third-party investors:
-
Parent owns all common stock of subsidiary — If the parent owns all of the subsidiary’s common stock, the entire amount of dividends on the subsidiary’s preferred stock will reduce the parent’s income available to common stockholders. If the subsidiary does not have any potential common stock, the calculation of EPS at the subsidiary level will generally not be necessary in the calculation of the parent’s EPS.
-
Third-party investors own common stock of the subsidiary (parent guaranteed dividends on subsidiary’s preferred stock) — When the parent guarantees dividends on its subsidiary’s preferred stock, the entire amount of such dividends will reduce the parent’s income available to common stockholders. By analogy to the guidance in ASC 480-10-S99-3A(22), no portion of such dividends should be allocated to the third-party investors in the subsidiary. See Section 3.2.3.3.1 for further discussion.
-
Third-party investors own common stock of subsidiary (parent did not guarantee dividends on subsidiary’s preferred stock) — If third-party investors own common stock of the subsidiary and the parent did not guarantee the subsidiary’s payment of preferred dividends, the dividends on the subsidiary’s preferred stock must be deducted from net income of the subsidiary to arrive at income available to the subsidiary’s common stockholders, which will represent the numerator in the subsidiary’s calculation of basic and diluted EPS. The parent will include its attributable portion of the subsidiary’s basic and diluted EPS in the numerator in the calculation of basic and diluted EPS of the consolidated group, as illustrated in Section 8.8.1.2. Because the common stock of the consolidated subsidiary is owned, in part, by third-party investors, the dividends on the subsidiary’s preferred stock will be allocated between the parent and third-party investors.
If the preferred stock is redeemable, dividends will include adjustments to the redemption amount of the preferred stock. See further discussion in Section 8.8.4.2.
8.8.2.2 Preferred Stock Issued by Subsidiary to Parent
A subsidiary may issue preferred stock to its parent. Because the preferred
stock is eliminated in the consolidated financial statements, dividends on
the preferred stock do not affect basic or diluted EPS of the consolidated
group. The example below discusses preferred stock issued by a subsidiary to
the parent as a means of funding dividends on preferred stock issued by the
parent.
Example 8-21
Preferred Stock Issued by Subsidiary to Its Parent
Assume the following:
- Subsidiary S is a majority-owned subsidiary of Company P, a public holding company.
- Company P issues to the public $100 million of Series A preferred stock that pays dividends at a rate of 5 percent per annum.
- In connection with the public offering of the Series A preferred stock, S issues to P $100 million of preferred stock that has the same terms as the Series A preferred stock (the “subsidiary preferred stock”). This issuance occurred as a means of funding dividends on the Series A preferred stock issued by the parent, since P is a holding company with no independent operations or cash flows.
- The Series A preferred stock is not convertible or mandatorily redeemable and does not meet the definition of a participating security.
In P’s consolidated financial statements, the subsidiary preferred stock does
not represent an NCI because it is eliminated. In
P’s calculation of basic and diluted EPS of the
consolidated group, the subsidiary preferred stock
has no impact on the calculation of basic or diluted
EPS because the shares and related dividends are
eliminated in consolidation. However, in the
calculation of basic and diluted EPS of the
consolidated group, dividends on the Series A
preferred stock should be deducted from net income
in arriving at income available to common
stockholders in accordance with ASC 260-10-45-11.
Since the Series A preferred stock is not
convertible and does not represent a participating
security, it has no other impact on P’s calculation
of basic and diluted EPS of the consolidated group.
8.8.2.3 Preferred Stock Issued by Subsidiary That Represents a Discontinued Operation
ASC 260 does not contain explicit guidance on the EPS accounting related to
situations in which a subsidiary that is classified as a discontinued
operation has issued preferred stock. However, dividends on a subsidiary’s
preferred stock classified in discontinued operations should not affect the
parent entity’s determination of income from continuing operations of the
consolidated group. Rather, the numerator adjustment for dividends
(including deemed dividends when the preferred stock is redeemable or has
been redeemed) should be only attributable to EPS amounts calculated for
discontinued operations. If the subsidiary has NCIs other than the preferred
stock, the dividends must be allocated between the parent and the other NCI
holders. See Section
8.8.2.1 for further discussion.
8.8.3 Application of Two-Class Method by Subsidiary
A subsidiary with multiple classes of common stock or participating securities
must apply the two-class method to calculate basic and diluted EPS. Even if the
subsidiary does not separately present EPS amounts, the subsidiary must apply
the two-class method so that its parent can calculate basic and diluted EPS for
the consolidated group. See Chapter 5 for discussion of participating securities and the
two-class method. See Section
8.8.4 for discussion of the application of the two-class method
of EPS to redeemable NCIs.
A subsidiary may have outstanding securities that participate in the parent’s earnings. These types of participating securities may not have any impact on the subsidiary’s calculations of basic and diluted EPS. That is, provided that these securities do not represent potential common shares of the subsidiary, they generally would not affect the subsidiary’s calculations of basic and diluted EPS. However, an allocation of the parent’s distributed and undistributed earnings under the two-class method, in accordance with the contractual participation rights of the securities, is required in the parent’s calculation of EPS for the consolidated group.
8.8.4 Redeemable NCIs
8.8.4.1 Background
Common and preferred shares issued by a consolidated subsidiary that are
classified as equity instruments are reported as an NCI in the consolidated
balance sheet of the parent (i.e., the reporting entity). An NCI may be
subject to redemption features whose exercise is outside the control of the
reporting entity (e.g., a put option). If the reporting entity is an SEC
registrant, it is subject to the classification and measurement guidance in
ASC 480-10-S99-3A. In accordance with the classification guidance in ASC
480-10-S99-3A, an NCI that is subject to redemption may need to be
classified in temporary equity in the reporting entity’s consolidated
balance sheet.17 Furthermore, in accordance with the subsequent-measurement guidance in
ASC 480-10-S99-3A, the reporting entity may be required to remeasure the NCI
to its redemption amount.18 This section addresses the EPS considerations related to NCIs that are
(1) classified in temporary equity in the reporting entity’s balance sheet
in accordance with the classification requirements of ASC 480-10-S99-3A and
(2) are being remeasured to their redemption amount in accordance with the
subsequent-measurement requirements of ASC 480-10-S99-3. In this section,
such NCIs are referred to as “redeemable NCIs.”
The accounting for redeemable NCIs is one of the more complex topics in U.S.
GAAP, in part because the reporting entity’s accounting depends on the
unique combination of the following:
-
The form of the redeemable NCI (common share vs. preferred share).
-
Whether the redemption price is at fair value or other than fair value.
-
The reporting entity’s policy for determining the amount of the adjustment to the redemption amount to be recorded in each period.
-
The reporting entity’s policy for classifying the offsetting entry to such adjustments.
-
When a common-share redeemable NCI is redeemable at other than fair value, the reporting entity’s policy for incorporating such adjustments into its EPS calculation.
Many of the financial reporting complexities pertain to the subsequent
measurement of redeemable NCIs. These measurement considerations are
discussed in this section to the extent that they affect the EPS accounting.
For more detailed discussion of the classification and measurement
considerations that apply to redeemable NCIs, see Chapter 9 of Deloitte’s Roadmap
Noncontrolling
Interests.
8.8.4.2 Types of Redemption Features and Prices
An NCI can be redeemed through mechanisms such as put option rights, a
combination of put and call option rights, or a forward purchase (sale)
agreement (collectively, “redemption features”). Examples of redemption
features embedded in NCIs include, but are not limited to:
-
Unilateral rights held by NCI holders to require the controlling interest holder to repurchase the subsidiary’s shares (e.g., put option) on some future date.
-
Redemption features that may be triggered by the occurrence (or, in some instances, nonoccurrence) of a contingent event (e.g., the occurrence of a debt downgrade or the nonoccurrence, by a specified date, of an IPO). Typically, the contingent event is outside the control of the NCI holder, issuer, and controlling interest holder, and its occurrence (or nonoccurrence) triggers either (1) exercisability of a put option held by the NCI holder or (2) settlement of a forward purchase agreement.
Generally, one of the following three methods (or some combination thereof) is
used to determine the redemption price of a redeemable NCI:
-
Redemption-date fair value — The redemption price is based on the fair value of the NCI at redemption and is determined through a third-party appraisal or another fair value measurement technique.Example 8-22NCI Redeemable at Fair ValueCompany A is the parent of Subsidiary B. Entity X holds a 20 percent NCI in B, and X’s NCI is puttable to A at fair value on the redemption date. On June 15, 20X7, X invokes its ability to put its 20 percent interest in B to A. As a condition of the redemption feature, A and X hire an appraiser to determine the current fair value of the 20 percent interest in B. Company A will then purchase the interest from X at the appraised fair value as of the redemption date.
-
Fixed price — The redemption price is fixed at a specified amount upon issuance of the redeemable NCI.Example 8-23NCI Redeemable at Fixed PriceCompany C is the parent of Subsidiary D, and Entity Y purchases a 15 percent NCI in D from C. Company C and Entity Y agree that Y can sell its 15 percent interest in D back to C for a fixed amount ($1 million) at any time during the next three years.
-
Specified formula — The redemption price is calculated on the basis of redemption-date inputs incorporated into a formula specified at the inception of the redeemable NCI. With limited exceptions, redemption features that are based on a prespecified formula do not ensure that the security will be redeemed at its fair value at the time of redemption. Footnote 18 of ASC 480-10-S99-3A states that “[c]ommon stock that is redeemable based on a specified formula is considered to be redeemable at fair value if the formula is designed to equal or reasonably approximate fair value. The SEC staff believes that a formula based solely on a fixed multiple of earnings (or other similar measure) is not considered to be designed to equal or reasonably approximate fair value.” Entities should use judgment when determining whether the formula is designed to equal or reasonably approximate fair value.Example 8-24NCI Redeemable at Formula-Driven PriceCompany E is the parent of Subsidiary F, and Entity Z holds a 25 percent NCI in F. Entity Z’s NCI is puttable to E at a price that Z calculates by using a prespecified formula on the redemption date. In this case, the prespecified formula redemption feature is 10 times trailing 12 months’ EBITDA as of the redemption date. On September 1, 20X7, Z invokes its ability to put its 25 percent interest in F to E. Company E must purchase the 25 percent interest in F from Z at an amount computed on the basis of the prespecified formula on the redemption date. The prespecified formula in this example does not ensure that the NCI will be redeemed at its fair value because the EBITDA multiple was set at inception and will not necessarily be the market multiple at the time the put is exercised. Therefore, this NCI should be accounted for as an NCI redeemable at other than fair value.
This section only discusses NCIs that are being remeasured to their redemption
amount. As a result, it does not address contingently redeemable NCIs for
which it is not probable that the instrument will become redeemable. As
further discussed in Section 8.8.4.3.2, the EPS implications differ for
common-share redeemable NCIs depending on whether such instruments are
redeemable at fair value or at an amount other than fair value (i.e., both
NCIs that are redeemable at a fixed price and NCIs that are redeemable at a
specified formula value). The reporting considerations related to NCIs that
are redeemable at other than fair value are significantly different from,
and more complex than, those related to NCIs that are redeemable at fair
value.
8.8.4.3 Impact of ASC 480-10-S99-3A Adjustments on EPS
8.8.4.3.1 General
In addition to affecting classification and subsequent measurement, the
redemption feature in a redeemable NCI could also have an impact on the
ASC 810 attribution19 of the subsidiary’s net income between the (1) controlling
interests and NCIs and (2) parent’s EPS calculations. Specifically:
-
Subsequent measurement of a redeemable NCI is governed by the policy elected for measuring NCIs that are not currently redeemable but whose redemption is probable.
-
The amount of a subsidiary’s net income that is attributed to NCIs on the face of the consolidated reporting entity’s income statement is affected by classification of the offsetting entry that accompanies any ASC 480-10-S99-3A measurement adjustment20 arising from ASC 480-10-S99-3A adjustments to the redeemable NCI’s carrying amount.21 Classification of this offsetting entry is affected, in turn, by a sequence of variables. The first variable is related to the form of the redeemable NCI (common shares vs. preferred shares). For a common-share redeemable NCI, the next variable is related to the nature of the redemption price (fair value vs. other than fair value). For a common-share redeemable NCI that is redeemable at other than fair value, the final variable is related to classification of this offsetting entry, which is governed by the reporting entity’s policy election for recording such adjustments (income attributable to NCI vs. retained earnings). This sequence of variables makes the accounting for redeemable NCIs one of the more complex aspects of U.S. GAAP to apply. An entity needs to properly consider these complexities to determine the appropriate EPS accounting.
-
The impact of a redeemable NCI on the parent’s EPS calculation depends on:
-
The parent’s policy for classifying the offsetting entry that accompanies any ASC 480-10-S99-3A measurement adjustment as either a component of equity or a component of net income attributable to NCIs.
-
The form of the redeemable NCI (common share vs. preferred share).
-
The nature of the redemption price (fair value vs. other than fair value) for a common-share redeemable NCI.
-
The entity’s policy for incorporating into its EPS calculation the fair value component of changes in a redemption price that is valued at other than fair value.
-
These topics are addressed in Sections 8.8.4.3.2 through 8.8.4.3.3.
The table below summarizes the effects of the various forms of redeemable NCIs
on the parent’s financial statements.
Table 8-7
Form of NCI/Redemption Price | Classification/Initial Measurement | Subsequent Measurement | Impact on Attribution of Earnings | Impact on EPS Calculation |
---|---|---|---|---|
Common share/fair value | Temporary equity/typically fair value(a) | Measure at higher of:
| None(d) | None(d) |
Common share/other than fair value | Temporary equity/typically fair value(a) | Measure at higher of:
| Depends on ASC 480-10-S99-3A offsetting entry policy election(e)
| Direct or indirect(e) |
Preferred share/any price | Temporary equity/typically fair value(a) | Measure in accordance with ASC 480-10-S99-3A(c) | Depends on ASC 480-10-S99-3A offsetting entry policy election(f) | Direct or indirect(f) |
Notes to Table: (a) See Sections
9.4.1 and 9.4.2 of
Deloitte’s Roadmap Noncontrolling
Interests for further discussion of
the classification and initial measurement of
redeemable NCIs. (b) The attribution of a subsidiary’s earnings to NCIs under ASC 810 occurs
before the application of ASC 480-10-S99-3A. As
discussed in detail in Chapter 6 of
Deloitte’s Roadmap Noncontrolling
Interests, a portion of a partially
owned subsidiary’s earnings is typically
attributed to NCIs in accordance with ASC 810. The
amount of a subsidiary’s earnings (loss)
attributed to an NCI generates a corresponding
increase (decrease) in the NCI’s carrying amount.
This ASC 810 attribution adjustment must be
recorded before the reporting entity records an
ASC 480-10-S99-3A measurement adjustment. (c) For NCIs that are not currently redeemable but whose redeemability is
probable in the future, a reporting entity may
elect, in accordance with ASC 480-10-S99-3A(15), a
policy of applying either of the following methods
of determining the amount of the measurement
adjustment after applying the measurement guidance
in ASC 810:
The policy elected should be consistently applied to all similar redeemable
equity instruments of the reporting entity. For
example, some reporting entities choose to apply
the accretion method to all redeemable NCIs that
are redeemable at a fixed price while applying the
immediate method to all redeemable NCIs that are
redeemable at fair value or by using a formula.
The immediate method always applies to NCIs that
are currently redeemable. While ASC 480-10-S99-3A(16)(e) states that “the amount presented in temporary
equity should be no less than the initial amount
reported in temporary equity for the instrument,”
this guidance is not intended to preclude the
attribution of a subsidiary’s losses to a
redeemable NCI (in accordance with ASC
810-10-45-19 through 45-21) from reducing the
carrying amount of the redeemable NCI below the
instrument’s initial carrying amount. That is,
while ASC 480-10-S99-3A(16)(e) does not allow for
the application of cumulative “negative”
measurement adjustments to the carrying amount of
a redeemable NCI, it also does not preclude the
recording of cumulative negative ASC 810
attribution adjustments. Note that if the carrying
amount of a redeemable NCI after the ASC 810
attribution adjustment is less than the redeemable
NCI’s redemption price, a subsequent measurement
adjustment under ASC 480-10-S99-3A should be
recorded to adjust the redeemable NCI’s carrying
amount to its redemption price. See Section 9.4.3
of Deloitte’s Roadmap Noncontrolling
Interests for further discussion of
the subsequent measurement of redeemable NCIs. (d) See Section
8.8.4.3.2.1. (e) See Section
8.8.4.3.2.2. (f) See Section
8.8.4.3.3. |
8.8.4.3.2 Common-Share Redeemable NCIs
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(21)
Common stock instruments issued by a parent (or
single reporting entity). Regardless of the
accounting method selected in paragraph 15, the
resulting increases or decreases in the carrying
amount of redeemable common stock should be
treated in the same manner as dividends on
nonredeemable stock and should be effected by
charges against retained earnings or, in the
absence of retained earnings, by charges against
paid-in capital. However, increases or decreases
in the carrying amount of a redeemable common
stock should not affect income available to common
stockholders. Rather, the SEC staff believes that
to the extent that a common shareholder has a
contractual right to receive at share redemption
(in other than a liquidation event that meets the
exception in paragraph 3(f)) an amount that is
other than the fair value of the issuer’s common
shares, then that common shareholder has, in
substance, received a distribution different from
other common shareholders. Under Paragraph
260-10-45-59A, entities with capital structures
that include a class of common stock with
different dividend rates from those of another
class of common stock but without prior or senior
rights, should apply the two-class method of
calculating earnings per share. Therefore, when a
class of common stock is redeemable at other than
fair value, increases or decreases in the carrying
amount of the redeemable instrument should be
reflected in earnings per share using the
two-class method.FN17 For common stock
redeemable at fair valueFN18, the SEC
staff would not expect the use of the two-class
method, as a redemption at fair value does not
amount to a distribution different from other
common shareholders. [Footnote reference 19
omitted]
S99-3A(22)
Noncontrolling interests. Paragraph
810-10-45-23 indicates that changes in a parent’s
ownership interest while the parent retains
control of its subsidiary are accounted for as
equity transactions, and do not impact net income
or comprehensive income in the consolidated
financial statements. Consistent with Paragraph
810-10-45-23, an adjustment to the carrying amount
of a noncontrolling interest from the application
of paragraphs 14–16 does not impact net income or
comprehensive income in the consolidated financial
statements. Rather, such adjustments are treated
akin to the repurchase of a noncontrolling
interest (although they may be recorded to
retained earnings instead of additional paid-in
capital). The SEC staff believes the guidance in
paragraphs 20 and 21 should be applied to
noncontrolling interests as follows:
-
Noncontrolling interest in the form of preferred stock instrument. The impact on income available to common stockholders of the parent arising from adjustments to the carrying amount of a redeemable noncontrolling interest other than common stock depends upon whether the redemption feature in the equity instrument was issued, or is guaranteed, by the parent. If the redemption feature was issued, or is guaranteed, by the parent, the entire adjustment under paragraph 20 reduces or increases income available to common stockholders of the parent. Otherwise, the adjustment is attributed to the parent and the noncontrolling interest in accordance with Paragraphs 260-10-55-64 through 55-67.
-
Noncontrolling interest in the form of common stock instrument. Adjustments to the carrying amount of a noncontrolling interest issued in the form of a common stock instrument to reflect a fair value redemption feature do not impact earnings per share. Adjustments to the carrying amount of a noncontrolling interest issued in the form of a common stock instrument to reflect a non-fair value redemption feature do impact earnings per share; however, the manner in which those adjustments reduce or increase income available to common stockholders of the parent may differ.FN20 If the terms of the redemption feature are fully considered in the attribution of net income under Paragraph 810-10- 45-21, application of the two-class method is unnecessary. If the terms of the redemption feature are not fully considered in the attribution of net income under Paragraph 810-10-45-20, application of the two-class method at the subsidiary level is necessary in order to determine net income available to common stockholders of the parent.
____________________
FN17 The two-class
method of computing earnings per share is
addressed in Section 260-10-45. The SEC staff
believes that there are two acceptable approaches
for allocating earnings under the two-class method
when a common stock instrument is redeemable at
other than fair value. The registrant may elect
to: (a) treat the entire periodic adjustment to
the instrument’s carrying amount (from the
application of paragraphs 14–16) as being akin to
a dividend or (b) treat only the portion of the
periodic adjustment to the instrument’s carrying
amount (from the application of paragraphs 14–16)
that reflects a redemption in excess of fair value
as being akin to a dividend. Under either
approach, decreases in the instrument’s carrying
amount should be reflected in the application of
the two-class method only to the extent they
represent recoveries of amounts previously
reflected in the application of the two-class
method.
FN18 Common stock
that is redeemable based on a specified formula is
considered to be redeemable at fair value if the
formula is designed to equal or reasonably
approximate fair value. The SEC staff believes
that a formula based solely on a fixed multiple of
earnings (or other similar measure) is not
considered to be designed to equal or reasonably
approximate fair value.
FN20 Subtopic 810-10 does not provide detailed guidance on the attribution of net income to the parent and the noncontrolling interest. The SEC staff understands that when a noncontrolling interest is redeemable at other than fair value some registrants consider the terms of the redemption feature in the calculation of net income attributable to the parent (as reported on the face of the income statement), while others only consider the impact of the redemption feature in the calculation of income available to common stockholders of the parent (which is the control number for earnings per share purposes).
A reporting entity with a common-share redeemable NCI within the scope of ASC
480-10-S99-3A should first apply the subsequent-measurement guidance in
ASC 810 and then apply the subsequent-measurement guidance in ASC
480-10-S99-3A. As a result, the NCI will be recorded at the higher of (1) the cumulative amount that would
result from applying the measurement guidance in ASC 810 (i.e., the
initial carrying amount, increased or decreased for the NCI’s share of
net income or loss, other comprehensive income or loss, and dividends)
or (2) the redemption price. Sometimes, this sequencing may result in
the need to subsequently reverse all or part of a prior-period ASC
480-10-S99-3A measurement adjustment (e.g., recording the ASC 810
attribution adjustment in the current period may increase the carrying
amount of the redeemable NCI above both (1) and (2), making it necessary
to reverse all or part of a prior-period ASC 480-10-S99-3A measurement
adjustment).
As explained below, classification of the ASC 480-10-S99-3A offsetting entry
that accompanies any ASC 480-10-S99-3A measurement adjustment is
governed by the nature of the redemption price (fair value vs. other
than fair value) and, for common-share redeemable NCIs that are
redeemable at other than fair value, the entity’s policy for recording
the ASC 480-10-S99-3A measurement adjustments and for incorporating them
into the parent’s EPS calculation.
8.8.4.3.2.1 Common-Share NCIs Redeemable at Fair Value
When the redemption price of a common-share redeemable NCI exceeds the NCI’s ASC
810 carrying amount after the attribution of income or loss to the
NCI, a reporting entity that is within the scope of ASC
480-10-S99-3A should record a measurement adjustment in accordance
with that guidance. Regardless of the classification of the
offsetting entry to the measurement adjustment under ASC
480-10-S99-3A (i.e., APIC or retained earnings), for a common-share
redeemable NCI that is redeemable at fair value, the ASC
480-10-S99-3A measurement adjustment has no impact on consolidated
net income of the parent, net income attributable to the parent, or
income available to common stockholders of the parent. Therefore,
the ASC 480-10-S99-3A measurement adjustment will have no impact on
EPS calculations.
8.8.4.3.2.2 Common-Share NCIs Redeemable at Other Than Fair Value
The ASC 480-10-S99-3A measurement adjustment for a common-share NCI redeemable
at other than fair value is intended, in part, to reflect the
liquidity being provided to the redeemable NCI holder for the entire
redemption price as well as to identify the NCI’s potential to
convey value to its holder that is incremental to the value that the
holder of a nonredeemable common-share NCI could receive in a
transaction conducted at fair value with an unrelated marketplace
participant. The multiple financial reporting objectives of this
measurement adjustment, coupled with the accepted diversity in
practice related to achieving these objectives, makes classification
of the offsetting entry to this ASC 480-10-S99-3A measurement
adjustment one of the more complex aspects of U.S. GAAP to apply to
redeemable NCIs.
To set the stage for the ensuing discussion and illustration of the various
approaches that are acceptable for achieving these financial
reporting objectives, a reporting entity must answer the following
threshold questions before it can determine the impact of the ASC
480-10-S99-3A measurement adjustment on its consolidated financial
statements:
-
To what extent does the reporting entity wish the ASC 480-10-S99-3A measurement adjustment to affect net income attributable to the parent, the parent’s reported EPS, or both? The reporting entity may elect one of the following approaches:
-
Have the entire amount of the reporting period’s ASC 480-10-S99-3A measurement adjustment affect net income attributable to the parent, the parent’s reported EPS, or both.
-
Limit the impact of the reporting period’s ASC 480-10-S99-3A measurement adjustment to the portion of this measurement adjustment necessary to ensure that, on a cumulative basis, net income attributable to the parent, the parent’s reported EPS, or both has been reduced by the amount, if any, by which the redeemable NCI’s redemption price exceeds both (1) the redeemable NCI’s fair value and (2) the redeemable NCI’s ASC 810 carrying amount. This portion is hereafter referred to as the “excess portion of the ASC 480-10-S99-3A measurement adjustment”22 or the excess portion of the ASC 480-10-S99-3A offsetting entry.The remaining portion of the ASC 480-10-S99-3A measurement adjustment necessary to ensure that the redeemable NCI’s period-end carrying amount equals the greater of its ASC 810 carrying amount or its redemption price is hereafter referred to as the “base portion of the ASC 480-10-S99-3A measurement adjustment”23 or the base portion of the ASC 480-10-S99-3A offsetting entry. On a cumulative basis, this will be the amount, if any, by which the redeemable NCI’s current redemption price is equal to or less than fair value but greater than the redeemable NCI’s ASC 810 carrying amount. This portion of the ASC 480-10-S99-3A measurement adjustment does not affect net income attributable to the parent or the parent’s reported EPS.
Note that while the latter approach may reduce the impact of the ASC 480-10-S99-3A measurement adjustment on net income attributable to the parent, the parent’s reported EPS, or both, it is also significantly more complex to apply since it focuses on ensuring that the cumulative impact of the redemption feature is isolated to the amount by which the redemption price exceeds both the redeemable NCI’s fair value and its ASC 810 carrying amount. Consequently, classification of each period’s ASC 480-10-S99-3A measurement adjustment is affected by both (1) the NCI’s redemption price, its ASC 810 carrying amount, and its fair value in the current period and (2) the amount and treatment of the ASC 480-10-S99-3A measurement adjustment recognized in prior periods. As a result of this approach’s focus on the cumulative impact of redeemable NCIs on net income attributable to the parent, the parent’s reported EPS, or both, the ASC 480-10-S99-3A measurement adjustment may comprise a positive base portion and a negative excess portion (or a negative base portion and a positive excess portion) in any given reporting period. -
-
If the reporting entity elects to have the entire amount of the ASC 480-10-S99-3A measurement adjustment affect net income attributable to the parent, the parent’s reported EPS, or both, how does the reporting entity wish to classify the entire offsetting entry that accompanies the ASC 480-10-S99-3A measurement adjustment?
-
If the reporting entity elects to limit the impact of the ASC 480-10-S99-3A measurement adjustment to the excess portion of the ASC 480-10-S99-3A measurement adjustment, how does the reporting entity wish to classify:
-
The base portion of the ASC 480-10-S99-3A measurement adjustment?
-
The excess portion of the ASC 480-10-S99-3A measurement adjustment?
-
The following approaches are acceptable for reflecting in consolidated financial
reporting the ASC 480-10-S99-3A measurement adjustment for
common-share redeemable NCIs redeemable at other than fair value and
represent possible responses to the questions above:
-
Income classification — entire adjustment method — Use net income (loss) attributable to NCIs to classify the entire ASC 480-10-S99-3A offsetting entry. Because net income (loss) attributable to NCIs directly affects income available to common stockholders of the parent, a reporting entity using this method is not required to make additional adjustments in calculating the parent’s EPS to accurately reflect the impact of the redemption feature (see Example 8-25).
-
Equity classification — entire adjustment method — Use retained earnings to classify the entire ASC 480-10-S99-3A offsetting entry. Because adjustments to retained earnings are not directly considered in net income attributable to the parent’s common shareholders, the parent must first apply the two-class method of calculating EPS at the subsidiary level, treating the entire amount of the ASC 480-10-S99-3A offsetting entry as an adjustment in the subsidiary’s EPS calculation. The resulting EPS amount determined at the subsidiary level for the class of subsidiary shares owned by the parent should then be used to determine the amount of subsidiary income that must be incorporated into the numerator of the parent’s EPS calculation (see Example 8-25).
-
Income classification — excess adjustment method — Use net income (loss) attributable to NCIs to classify only the excess portion of the ASC 480-10-S99-3A offsetting entry. The base portion of the ASC 480-10-S99-3A offsetting entry may be consistently classified in either of the following:
-
Retained earnings (or APIC in the absence of retained earnings) — The guidance in ASC 480-10-S99-3A(21) on classifying offsetting entries for redeemable parent common shares in retained earnings (or APIC in the absence of retained earnings) justifies the acceptability of this approach for classifying in retained earnings the base portion of the ASC 480-10-S99-3A offsetting entry (see Example 8-26).
-
APIC — Upon considering the guidance in ASC 810-10-45-23 requiring that changes in a parent’s ownership interest be accounted for as equity transactions, one can conclude that it is acceptable to use this approach to classify in APIC the base portion of the ASC 480-10-S99-3A offsetting entry (see Example 8-26).
-
-
Equity classification — excess adjustment method — Always use retained earnings (or APIC in the absence of retained earnings) to classify the excess portion of the ASC 480-10-S99-3A offsetting entry. The base portion of the ASC 480-10-S99-3A offsetting entry may be consistently classified as either:
-
Retained earnings (or APIC in the absence of retained earnings) — As noted above in the description of the “income classification — excess adjustment method,” the acceptability of this approach for classifying in retained earnings the base portion of the ASC 480-10-S99-3A offsetting entry can be justified on the basis of the guidance in ASC 480-10-S99-3A(21) (see Example 8-27).
-
APIC — As noted above in the description of the “income classification — excess adjustment method,” the acceptability of this approach for classifying in APIC the base portion of the ASC 480-10-S99-3A offsetting entry can be justified on the basis of the guidance in ASC 810-10-45-23 (see Example 8-27).
-
The first two approaches are governed by the parent’s election (in accordance
with footnote 17 of ASC 480-10-S99-3A) to reflect the entire amount
of the ASC 480-10-S99-3A measurement adjustment as being akin to a
dividend that directly (income classification — entire adjustment
method) or indirectly (equity classification — entire adjustment
method) affects the parent’s EPS calculation. The second two
approaches are governed by the parent’s election (in accordance with
footnote 17 of ASC 480-10-S99-3A) to reflect only the excess portion
of the ASC 480-10-S99-3A measurement adjustment as being akin to a
dividend that directly (income classification — excess adjustment
method) or indirectly (equity classification — excess adjustment
method) affects the parent’s EPS calculation. Each of the excess
adjustment methods has acceptable subpolicies that must be elected
to clarify what component of shareholders’ equity (retained earnings
or APIC) is used to classify the base portion of the ASC
480-10-S99-3A measurement adjustment).
While the approaches above are acceptable alternatives, a reporting entity
should generally consistently apply (and appropriately disclose) the
same method for its entire portfolio of less than wholly owned
subsidiaries. Further, as previously noted, although the excess
adjustment methods could potentially reduce the cumulative impact of
a redeemable NCI on net income attributable to the parent or the
parent’s reported EPS, the cumulative focus of these approaches
makes them significantly more complex to apply (which is why many
reporting entities elect to apply one of the entire adjustment
methods in practice). Given the significance of both net income
attributable to the parent and income available to common
stockholders of the parent (the numerator of the parent’s EPS
calculation), reporting entities that elect to apply one of the
excess adjustment methods should ensure that they have adequate
internal control over financial reporting to minimize the risk of a
material misstatement.
The acceptability of the income classification and equity classification methods
(provided that the method selected is consistently applied to the
parent’s entire portfolio of less than wholly owned subsidiaries) is
consistent with the diversity in practice acknowledged by the SEC
staff in footnote 20 of ASC 480-10-S99-3A, which states, in part:
The SEC staff understands that when a
noncontrolling interest is redeemable at other than fair value
some registrants consider the terms of the redemption feature in
the calculation of net income attributable to the parent (as
reported on the face of the income statement), while others only
consider the impact of the redemption feature in the calculation
of income available to common stockholders of the parent (which
is the control number for earnings per share purposes).
Note that unless otherwise indicated, under all of the adjustment methods, as
well as in Examples 8-25 through 8-27, it is presumed that the
common-share NCI is redeemable by the subsidiary itself (as opposed
to being redeemable or guaranteed by the parent). Although the
mechanics may be different, the accounting outcomes would be
expected to be the same on a consolidated basis when the adjustment
methods illustrated in Examples 8-25 through 8-27 are
applied, regardless of whether the common-share NCI is redeemable by
the subsidiary itself or by the parent when the nonredeemable common
shares of the subsidiary are held entirely by the parent. The
outcomes may differ if the nonredeemable common shares of the
subsidiary are also held by other third parties.
In accordance with SAB Topic 6.B, an SEC registrant that elects to use an equity classification method must present income or loss applicable to common stockholders on the face of the consolidated statement of income “when [those earnings are] materially different in quantitative terms from reported net income or loss [attributable to the parent] or when [those earnings are] indicative of significant trends or other qualitative considerations.” (See Section 9.1.6 for further discussion of this reporting requirement.) Otherwise, an SEC registrant that elects to use an equity classification method can present such amounts in the footnotes to the consolidated financial statements.
8.8.4.3.2.3 Examples of Common-Share NCIs Redeemable at Other Than Fair Value
Example 8-25
Application of Entire Adjustment Methods Related to Income Classification and Equity Classification, Respectively
Assume the following:
- Company G is the parent of Subsidiary H.
- Entity I holds a 20 percent NCI in the common shares of H, which it acquired from G on January 1, 20X6, for $1.1 million (which is the initial carrying amount of the NCI).
- The NCI is redeemable at the option of I at a formulaic redemption price that does not equal fair value.
- Company G has elected to use the immediate method to record ASC 480-10-S99-3A measurement adjustments.
- Company G determines the fair value of I’s NCI at the end of each reporting period.
- Neither G nor H has any outstanding securities other than those described above.
- Company G has sufficient retained earnings to cover any portion of ASC 480-10-S99-3A offsetting entries that are classified in retained earnings.
- To classify its ASC 480-10-S99-3A offsetting entry and calculate EPS, G applies either (1) the income classification — entire adjustment method or (2) the equity classification — entire adjustment method.
The parties’ respective interests are illustrated in the diagram below.
The following amounts will be relevant to G’s financial reporting for the period ended 20X6 (all numbers in thousands):
20X6
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X6, G uses the journal entries below to
subsequently measure I’s NCI in H.
EPS Impact
Income Classification — Entire Adjustment Method
For the period ended December 31, 20X6, because income attributable to the NCI
directly affects net income attributable to G’s
common stockholders, use of the income
classification — entire adjustment method does not
necessitate additional adjustments to arrive at
the control number of G’s EPS calculation. Company
G will report net income attributable to its
common stockholders and income available to common
stockholders (the control number of EPS) of
$1,797,000, as shown in the table below.
Equity Classification — Entire Adjustment Method
Under the equity classification — entire adjustment method, the ASC
480-10-S99-3A measurement adjustment to the
redeemable NCI does not affect G’s reported
amounts of consolidated net income and net income
attributable to common stockholders of G. However,
G must apply the two-class method at the
subsidiary level, recognizing the entire amount of
the ASC 480-10-S99-3A offsetting entry as income
distributed to the NCI holders of H, to arrive at
income available to common stockholders (the
control number of EPS). After applying the
two-class method, G will report income available
to common stockholders (the control number of EPS)
of $1,797,000, which is the same amount as that
resulting from application of the income
classification — entire adjustment method.
Therefore, under both methods, G will report the
same EPS amounts in this example. The calculations
under the equity classification — entire
adjustment method are shown below.
Application of the two-class method at the subsidiary level has been simplified by the lack of (1) declared dividends of H and (2) any other participating securities or potential common shares at the subsidiary or parent level.
For an illustration of the accounting under the two applicable methods for
additional years by using the same assumptions as
in this example, see Example 9-6 in
Deloitte’s Roadmap Noncontrolling
Interests.
Example 8-26
Application of Income Classification — Excess Adjustment Method (APIC or Retained Earnings)
Assume the same facts as in the example above, except that Company G has elected
to apply the income classification — excess
adjustment method, including one of the method’s
required subpolicies (APIC or retained earnings).
This illustrative example highlights the financial
reporting and EPS impact of applying the method
and each subpolicy. For ease of reference, we have
repeated the facts and figures that will be
relevant to G’s financial reporting for the period
ended 20X6 and have added facts for the periods
ended 20X7, 20X8, and 20X9 to illustrate this
approach in various scenarios.
In this example:
- Subsidiary H has 1 million common shares outstanding, of which G holds 800,000 and Entity I holds 200,000.
- Subsidiary H has no securities outstanding other than those described above.
- Company G has 1 million common shares outstanding for all periods.
- Company G has no potential common shares.
Key figures associated with G, H, and the NCI that I holds in H are as follows
(all numbers in thousands):
20X6
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X6, G uses the journal entries below to
subsequently measure I’s NCI in H under the income
classification — excess adjustment method
(APIC/retained earnings).
EPS Impact
Because G has elected to apply the income classification — excess adjustment
method (including one of the method’s required
subpolicies), net income attributable to G’s
common stockholders will be directly affected by
the portion of the ASC 480-10-S99-3A offsetting
entry that reflects the cumulative excess (if any)
of the NCI’s redemption price over the
instrument’s fair value. Accordingly, regardless
of G’s classification (APIC or retained earnings)
of the portion of the ASC 480-10-S99-3A offsetting
entry arising from redemption prices below fair
value, no additional adjustment to net income
attributable to G’s common stockholders is
necessary to arrive at income available to common
stockholders (the control number for G’s EPS
calculation). With respect to this period, because
100 percent of the ASC 480-10-S99-3A measurement
adjustment is related to a redemption price that
is less than fair value, none of the ASC
480-10-S99-3A offsetting entry is classified in
net income attributable to NCIs. Accordingly, G
reports net income attributable to G and income
available to common stockholders of $1,820,000 for
20X6, as shown in the table below.
20X7
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A
Measurement Adjustment/Offsetting
Entry
For the period ended December 31, 20X7, G uses the journal entries below to
subsequently measure I’s NCI in H.
EPS Impact
The 20X7 period-end carrying amount of the NCI is solely related to the NCI’s
initial measurement ($1,100,000) plus cumulative
attribution of earnings to the NCI ($345,000)
since this amount ($1,445,000) exceeds the NCI’s
redemption price ($1,414,000). Consequently, 100
percent of the ASC 480-10-S99-3A measurement
adjustment for 20X7 reflects a reversal of the
20X6 ASC 480-10-S99-3A measurement adjustment.
Because the 20X6 ASC 480-10-S99-3A measurement
adjustment arose from a 20X6 redemption price
($1,278,000) that was less than the NCI’s 20X6
fair value ($1,350,000), the 20X6 ASC
480-10-S99-3A measurement adjustment was
classified in equity under the income
classification — excess adjustment method and did
not affect net income attributable to NCIs or
income available to common stockholders. As a
result, the entire amount of the 20X7 ASC
480-10-S99-3A measurement adjustment is also
classified in equity and does not affect net
income attributable to G or income available to
common stockholders. Otherwise, G would be
provided with an EPS benefit in 20X7 related to
the reversal of a 20X6 item that did not itself
negatively affect the 20X6 EPS calculation.
Accordingly, for 20X7, G reports net Income
attributable to G and income available to common
stockholders of $2,110,000, as shown in the table
below.
20X8
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X8, G uses the journal entries below to
subsequently measure I’s NCI in H.
EPS Impact
Because 100 percent of the ASC 480-10-S99-3A measurement adjustment for 20X8
arises from a redemption price that exceeds the
redeemable NCI’s fair value, all of the ASC
480-10-S99-3A offsetting entry is classified in
net income attributable to NCIs. Accordingly, G
reports net income attributable to G and income
available to common stockholders of $2,585,000, as
shown in the table below.
20X9
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X9, G uses the journal entries below to
subsequently measure I’s NCI in H.
EPS Impact
Of the ASC 480-10-S99-3A measurement adjustment for 20X9, $23,000 is related to
the amount necessary to recognize (on a cumulative
basis) in net income attributable to NCIs the
excess of the redemption price over the redeemable
NCI’s fair value. The remaining $17,000 of the ASC
480-10-S99-3A offsetting entry is classified in
APIC or retained earnings (depending on G’s policy
election). Accordingly, for 20X9, the parent
reports net income attributable to G and income
available to common stockholders of $2,077,000, as
shown in the table below.
Company G would report the following EPS amounts for 20X6, 20X7, 20X8, and 20X9:
Example 8-27
Application of Equity Classification — Excess Adjustment Method (APIC or Retained Earnings)
Assume the same facts as in Example 8-25, except that Company G
has elected to apply the equity classification —
excess adjustment method, including one of the
method’s required subpolicies (APIC or retained
earnings). This illustrative example highlights
the financial reporting and EPS impact of applying
the method and each subpolicy. For ease of
reference, we have repeated the facts and figures
that will be relevant to G’s financial reporting
for the period ended 20X6 and have added the same
facts as those added in Example 8-26 for
the periods ended 20X7, 20X8, and 20X9 to
illustrate this approach in various scenarios.
In this example:
- Subsidiary H has 1 million common shares outstanding, of which G holds 800,000 and Entity I holds 200,000.
- Subsidiary H has no securities outstanding other than those described above.
- Company G has 1 million common shares outstanding for all periods.
- Company G has no potential common shares.
Key figures associated with G, H, and the NCI that I holds in H are as follows
(all numbers in thousands):
20X6
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X6, G uses the journal entries below to
subsequently measure I’s NCI in H under the equity
classification — excess adjustment method
(APIC/retained earnings).
20X7
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X7, G uses the journal entries below to
subsequently measure I’s NCI in H.
20X8
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X8, G uses the journal entries below to
subsequently measure I’s NCI in H.
For 20X8, all of the 20X8 ASC 480-10-S99-3A offsetting entry is classified in retained earnings under either subpolicy of the equity classification — excess adjustment method. This is because under that method, retained earnings (or APIC in the absence of retained earnings) are used to classify the excess portion of the ASC 480-10-S99-3A offsetting entry and for 20X8, there is no base portion of the ASC 480-10-S99-3A offsetting entry. Further, as stated in the facts, G has sufficient retained earnings to absorb the $15,000 debit arising from the ASC 480-10-S99-3A measurement adjustment.
20X9
ASC 810 Attribution Adjustment/ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
For the period ended December 31, 20X9, G uses the journal entries below to
subsequently measure I’s NCI in H.
Of the ASC 480-10-S99-3A measurement adjustment for 20X9, $23,000 is related to
the amount necessary to recognize (on a cumulative
basis) the amount by which the redemption price
exceeds the redeemable NCI’s fair value. Under the
equity classification — excess adjustment method,
this amount (i.e., the excess portion of the ASC
480-10-S99-3A measurement adjustment) must be
classified in retained earnings. The remaining
$17,000 of the ASC 480-10-S99-3A offsetting entry
(i.e., the base portion of the ASC 480-10-S99-3A
measurement adjustment) is classified in APIC or
retained earnings (depending on G’s policy
election).
EPS Impact for All Years
Under the equity classification — excess adjustment method, the ASC
480-10-S99-3A measurement adjustments to the
redeemable NCI do not affect G’s reported amounts
of consolidated net income and net income
attributable to common stockholders of G. However,
G must apply the two-class method at the
subsidiary level to reflect the impact of
redemption price adjustments that exceed fair
value in its calculations of EPS. Under the
two-class method, the portion of the ASC
480-10-S99-3A offsetting entry that reflects the
excess (if any) of the NCI’s redemption price over
the instrument’s fair value is not treated as a
distribution to the NCI holders (i.e., it has no
impact on EPS). The portion of the ASC
480-10-S99-3A offsetting entry that reflects the
excess (if any) of the redemption price of the NCI
over the instrument’s fair value is treated as a
distribution on the NCI (i.e., it affects EPS).
The two-class method is applied at the subsidiary
level under this method to determine the portion
of the subsidiary’s income that is included in
income available to common stockholders of the
parent (the control number of EPS).
The following table illustrates the calculations of income available to common stockholders for each period:
As can be seen from the table
above, the reported amounts of income available to
common stockholders and basic and diluted EPS are
the same as in Example 8-26.
However, this may not always be the case,
especially for entities with complex capital
structures.
8.8.4.3.3 Preferred-Share Redeemable NCIs
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(22) Noncontrolling interests. Paragraph 810-10-45-23 indicates that changes in a parent’s ownership interest while the parent retains control of its subsidiary are accounted for as equity transactions, and do not impact net income or comprehensive income in the consolidated financial statements. Consistent with Paragraph 810-10-45-23, an adjustment to the carrying amount of a noncontrolling interest from the application of paragraphs 14–16 does not impact net income or comprehensive income in the consolidated financial statements. Rather, such adjustments are treated akin to the repurchase of a noncontrolling interest (although they may be recorded to retained earnings instead of additional paid-in capital). The SEC staff believes the guidance in paragraphs 20 and 21 should be applied to noncontrolling interests as follows:
- Noncontrolling interest in the form of preferred stock instrument. The impact on income available to common stockholders of the parent arising from adjustments to the carrying amount of a redeemable noncontrolling interest other than common stock depends upon whether the redemption feature in the equity instrument was issued, or is guaranteed, by the parent. If the redemption feature was issued, or is guaranteed, by the parent, the entire adjustment under paragraph 20 reduces or increases income available to common stockholders of the parent. Otherwise, the adjustment is attributed to the parent and the noncontrolling interest in accordance with Paragraphs 260-10-55-64 through 55-67.
Like the ASC 480-10-S99-3A measurement adjustment used for common-share
redeemable NCIs, the ASC 480-10-S99-3A measurement adjustment for
preferred-share redeemable NCIs is partly intended to reflect the
liquidity provided by such features and the potential for the interests
to convey value to their holder in excess of their initial carrying
amount and any associated dividend rights. A reporting entity should
classify ASC 480-10-S99-3A offsetting entries for preferred-share
redeemable NCIs by applying the same classification policy it elected
for recording preferred dividends of a subsidiary in the parent’s
financial statements (see Example 3-10 and Section 6.8 of
Deloitte’s Roadmap Noncontrolling Interests). However, unlike
common-share redeemable NCIs for which an offsetting entry is made under
ASC 480-10-S99-3A, the periodic measurement adjustment for
preferred-share redeemable NCIs should not be bifurcated into components
corresponding to changes in redemption price in excess of fair value
(i.e., the excess portion) and changes less than fair value (i.e., the
base portion). Rather, the entire amount of the ASC 480-10-S99-3A
offsetting entry is recorded in a manner akin to the recording of a
dividend to reflect that changes in the redemption price of
preferred-share redeemable NCIs ultimately affect net assets that would
otherwise be available to common shareholders of the parent. The
following classification methods may be used:
-
Preferred-share income classification method — Use net income (loss) attributable to preferred-share NCIs to classify the entire ASC 480-10-S99-3A offsetting entry.
-
Preferred-share equity classification method — Classify the ASC 480-10-S99-3A offsetting entry as an adjustment to retained earnings (or APIC in the absence of retained earnings).
The method applied must be used for all preferred-share redeemable NCIs. Under
either classification method, ASC 480-10-S99-3A(22) requires that “[i]f
the redemption feature was issued, or is guaranteed, by the parent, the
entire [ASC 480-10-S99-3A offsetting entry] reduces or increases income
available to common stockholders of the parent. Otherwise, the
adjustment is attributed to the parent and the noncontrolling
interest.”
The example below illustrates the application of the two classification methods
to preferred-share NCIs that are redeemable by the parent.
Example 8-28
Preferred-Share Redeemable NCI
Assume the following:
- Company A owns all of the outstanding common shares of Subsidiary B.
- On January 1, 20X7, Subsidiary B issued a preferred-share NCI to Entity C, an unrelated third party, for $1 million. The interest represents all of B’s outstanding preferred securities.
- The preferred securities are not entitled to dividends but are redeemable by A at their holder’s option for $1.25 million beginning on December 31, 20X8 (two years after issuance).
- Company A has elected to apply the accretion method and uses the interest method to accrete the redeemable NCI to the interest’s redemption price.
Company A has determined that an effective interest rate of 11.803 percent
results in the full accretion of the NCI to its
redemption price by December 31, 20X8. Company A
subsequently measures the NCI at the following
amounts:
Assume also that:
- Company A and Subsidiary B report the following net income for 20X7 and 20X8:For A, the amounts reported do not include A’s investment in B.
- Company A and its subsidiary have no intercompany transactions that must be eliminated.
- Company A has sufficient retained earnings to cover ASC 480-10-S99-3A offsetting entries that are classified in retained earnings.
ASC 480-10-S99-3A Measurement Adjustment/Offsetting Entry
Company A uses the journal entries below to subsequently measure C’s NCI in
B.
EPS Impact
Preferred-Share Income Classification Method
For the periods ended December 31, 20X7, and December 31, 20X8, the income classification method will directly affect net income attributable to A. As shown in the tables below, A will report net income attributable to A and income available to common stockholders of $14,318,966 and $16,455,034 in 20X7 and 20X8, respectively.
Preferred-Share Equity Classification Method
For the periods ended December 31, 20X7, and December 31, 20X8, the equity
classification method will not directly affect net
income attributable to A. Consequently, even in
the absence of a common-share NCI, A will be
required to record an adjustment to net income
attributable to A to arrive at income available to
common stockholders. As shown in the tables below,
A will report net income attributable to A of
$14,437,000 and $16,587,000 in 20X7 and 20X8,
respectively, and income available to common
stockholders of $14,318,966 and $16,455,034 for
the same periods.
Under both methods, income available to common stockholders (the control number of EPS) is the same; therefore, regardless of which method is applied, EPS would be the same.
Connecting the Dots
As previously discussed, a reporting entity can use either an entire adjustment
method or an excess adjustment method to classify a common-share
redeemable NCI’s ASC 480-10-S99-3A offsetting entry and
determine the EPS impact of such an interest’s ASC 480-10-S99-3A
measurement adjustment. However, for preferred-share redeemable
NCIs, it is not acceptable to bifurcate the ASC 480-10-S99-3A
offsetting entry into an excess portion and a base portion.
Rather, the entire amount of the preferred-share redeemable
NCI’s ASC 480-10-S99-3A measurement adjustment should affect the
parent’s EPS calculation directly (through application of the
income classification method) or indirectly (through application
of the equity classification method and an accompanying
adjustment to arrive at income available to the parent’s common
stockholders).
In the example above, it is assumed that the preferred-share NCI held by Entity
C is redeemable by Company A, the 100 percent owner of
Subsidiary B’s common shares. Consequently, 100 percent of the
ASC 480-10-S99-3A measurement adjustment, which affects EPS, has
been attributed to A as the counterparty to the redemption
feature. If the preferred-share NCI held by C were redeemable by
B itself, the resulting impact of the ASC 480-10-S99-3A
measurement adjustment, which affects EPS, would be attributed
to B’s common shareholder(s). Although the mechanics may differ,
because A is the sole common shareholder of B, the accounting
outcome would be expected to be the same on a consolidated
basis regardless of whether the preferred-share NCI is
redeemable by the subsidiary itself or by the parent. If, on the
other hand, B’s common shares are held by multiple investors
(rather than by A alone) and (1) the parent does not guarantee
the redemption of the subsidiary preferred stock and (2) there
are no other contractual arrangements that could shift the
allocation of income or loss between the common shareholders,
the impact of the ASC 480-10-S99-3A measurement adjustment would
be attributed to the parent and the common-share NCI holders on
the basis of their common-share ownership percentages. This
allocation would affect calculations of EPS.
In accordance with SAB Topic 6.B, an SEC registrant that elects to use an equity classification method must present income or loss applicable to common stockholders on the face of the consolidated statement of income “when [those earnings are] materially different in quantitative terms from reported net income or loss [attributable to the parent] or when [those earnings are] indicative of significant trends or other qualitative considerations.” Otherwise, an SEC registrant that elects to use an equity classification method can present such amounts in the footnotes to the consolidated financial statements. See Section 9.1.6 for further discussion of this reporting requirement.
8.8.4.4 Impact of Redemption Accounting on EPS
An entity should apply the guidance in ASC 810-10-45-23 to account for the
acquisition of an NCI. ASC 810-10-45-23 states, in part, that “[c]hanges in
a parent’s ownership interest while the parent retains its controlling
financial interest in its subsidiary shall be accounted for as equity
transactions.” See Section
7.1 of Deloitte’s Roadmap Noncontrolling Interests for
additional details on accounting for changes in a parent’s ownership
interest. In addition to the discussion below, see Section 3.2.3.3 for
more information about the redemption of redeemable NCIs.
8.8.4.4.1 Redemptions of Common-Share NCIs
With respect to redemptions of NCIs in the form of common shares, reporting
entities may apply different accounting policies to reflect the actual
repurchase of such interests. Some reporting entities that apply the
equity classification adjustment methods first reverse ASC 480-10-S99-3A
measurement adjustments that were previously recognized in retained
earnings before accounting for the actual redemption. Other reporting
entities choose not to make such reversing entries. These alternative
policies only affect whether the excess (shortfall) of the repurchase
price over (below) the initial amount recorded to equity is reflected as
a reduction (increase) in retained earnings or a reduction (increase) in
APIC. For an entity that applies a reversal policy (i.e., reverses
previously recorded ASC 480-10-S99-3A measurement adjustments in
retained earnings before reflecting the redemption), the reversing entry
should be limited to amounts previously recognized in retained earnings
that did not affect EPS.
For more information about these equity classification adjustment methods and to
understand the extent to which they affect the reporting entity’s EPS
calculation, see the discussion of common-share NCIs redeemable at fair
value (Section
8.8.4.3.2.1) and the discussion of common-share NCIs
redeemable at other than fair value (Section 8.8.4.3.2.2).
8.8.4.4.2 Redemptions of Preferred-Share NCIs
With respect to redemptions of NCIs in the form of preferred shares, ASC
260-10-S99-2 states, in part:
The SEC staff believes
that the difference between the fair value of the consideration
transferred to the holders of the preferred stock and the carrying
amount of the preferred stock in the registrant’s balance sheet
represents a return to (from) the preferred stockholder that should
be treated in a manner similar to the treatment of dividends paid on
preferred stock.
Thus, if the price at which the preferred shares are redeemed differs from their carrying amount, the reporting entity should apply the accounting guidance in ASC 260-10-S99-2 to determine whether there is an additional EPS impact related to the difference in price.
Note also that if the consideration transferred to
redeem NCIs in the form of preferred shares does not reflect the fair
value of the redeemed shares, the transaction involves other elements
that should be accounted for in accordance with other GAAP.
8.8.4.5 Expiration of a Redemption Feature
If the redemption feature embedded in the NCI expires without being exercised,
the carrying amount of the NCI should be reclassified into permanent equity
of the parent. The previously recorded excess amounts should not be
reversed; therefore, previous amounts that affected EPS should also not be
reversed or otherwise cause an adjustment to EPS in the period of the
reclassification. Specifically, ASC 480-10-S99-3A(18) states, in part:
[T]he existing carrying amount of the equity instrument
should be reclassified to permanent equity at the date of the event that
caused the reclassification. Prior financial statements are not
adjusted. Additionally, the SEC staff believes that it would be
inappropriate to reverse any adjustments previously recorded to the
carrying amount of the equity instrument (pursuant to paragraphs 14–16)
in conjunction with such reclassifications.
8.8.5 Reciprocal Interests
When an investor holds an equity investment in an investee (i.e., a consolidated subsidiary or an equity method investee) and the investee concurrently holds an investment in the investor, such investments are known as reciprocal interests. ASC 260 does not specifically address the impact of reciprocal interests on the calculation of EPS. The accounting for reciprocal interests in consolidated subsidiaries and equity method investees on the basis of the approaches commonly applied in practice is further discussed below.
8.8.5.1 Consolidated Subsidiaries
In a manner consistent with the concept of a single economic entity and the
guidance in ASC 810-10-45-5, reciprocal interests should generally be
presented as treasury shares on the parent’s consolidated balance sheet
regardless of the extent of the parent’s ownership interest in its
subsidiary. That is, 100 percent of a subsidiary’s interests in its parent
should generally be reported as treasury shares in the parent’s consolidated
financial statements even if the subsidiary is not wholly owned by the
parent. See Example
4-2 of Deloitte’s Roadmap Noncontrolling Interests for an
illustration of this concept.
In the parent’s consolidated income statement, the existence of reciprocal
interests affects the allocation of the consolidated entity’s earnings
between the parent’s third-party shareholders and the subsidiary’s NCI
holders, since the subsidiary’s NCI holders indirectly own a portion of the
parent’s common stock. In practice, there are two methods of attributing
earnings of the consolidated entity: the treasury stock method and the
simultaneous equations method:24
-
Treasury stock method — EPS of the consolidated group is calculated by reducing the weighted-average number of the parent’s common shares outstanding by the number of common shares owned by the subsidiary that may be deemed to be owned by the parent through its ownership interest in the subsidiary. The theory underlying this method is that a portion of the parent’s common shares owned by the subsidiary are treasury shares and that those shares therefore should not be considered outstanding in the calculation of EPS.
-
Simultaneous equations method — EPS of the consolidated group is calculated by (1) excluding all the parent’s common shares owned by the subsidiary from the weighted-average number of the parent’s common shares outstanding and (2) adjusting the parent’s income available to common stockholders to exclude an amount of the subsidiary’s earnings or losses that results from owning the parent’s common stock; this amount would be calculated by using complex algebraic formulas.
Use of the treasury stock method is more common because entities that use the simultaneous equations method must apply complex algebraic concepts. Although the parent’s income available to common stockholders under the treasury stock method may differ from that under the simultaneous equations method, consolidated net income will be the same under both methods. Further, because of accompanying differences in the number of parent shares that will be included in the calculation of the parent’s EPS, each method will also produce the same reported EPS amounts. Thus, either method is acceptable as long as it is applied consistently to all reciprocal interests.
See Example 6-10 in
Deloitte’s Roadmap Noncontrolling Interests for an illustration of
each method.
8.8.5.2 Equity Method Investees
The investor should present reciprocal interests as a reduction of both its
investment in the equity method investee and its equity in the investee’s
earnings. In practice, there are two methods of calculating the investee’s
earnings: the treasury stock method and the simultaneous equations method.
Application of the treasury stock method tends to be more common since, as
illustrated in Section
6.6 of Deloitte’s Roadmap Noncontrolling Interests, the
simultaneous equations method can be very complex. However, either method is
acceptable as long as an investor applies it consistently to all reciprocal
interests. Under the treasury stock method, the equity method investor
considers its shares held by the equity method investee to be treasury
stock. Therefore, the investor records its share of the investee’s net
income, excluding the equity method earnings from the investee’s equity
method investment in the investor. Example 5-19 in Deloitte’s Roadmap
Equity Method
Investments and Joint Ventures illustrates the
application of the treasury stock method to reciprocal interests of an
equity method investee.
Footnotes
14
It is assumed that the
potential common stock is dilutive.
15
In this table, unless
otherwise noted, it is assumed that the options on
common stock (1) must be share-settled upon
exercise, (2) are classified within stockholders’
equity in the parent’s consolidated financial
statements, and (3) do not meet the definition of
a participating security. See Section
4.7 for a discussion of the EPS
accounting related to situations in which a stock
option may be settled in cash or stock or is
classified as a liability. See Section
8.8.3 for a discussion of the EPS
accounting for participating securities of a
less-than-wholly-owned consolidated
subsidiary.
16
In this table, unless
otherwise noted, it is assumed that the
convertible debt (1) must be share-settled upon
exercise (i.e., no portion of the instrument may
be settled in cash), (2) does not contain an
embedded conversion option that must be separately
accounted for as a derivative instrument, and (3)
does not meet the definition of a participating
security. See Section 8.8.3
for a discussion of the EPS accounting for
participating securities of a
less-than-wholly-owned consolidated
subsidiary.
17
NCIs may need to be classified in temporary equity
if they are puttable to the issuing entity, the parent entity, or a
consolidated subsidiary of the parent entity. See Section 9.3
of Deloitte’s Roadmap Noncontrolling
Interests for further discussion of the
requirements in ASC 480-10-S99-3A related to temporary equity
classification.
18
When an NCI is subject to the measurement guidance
in ASC 480-10-S99-3A, the parent entity should first apply the
recognition and measurement guidance in ASC 810 to the NCI. The
measurement guidance in ASC 480-10-S99-3A is applied after the
application of ASC 810. A reporting entity’s application of ASC
480-10-S99-3A does not exonerate the entity from the requirements of
the accounting and disclosure guidance in ASC 810. See Section 9.4.3
of Deloitte’s Roadmap Noncontrolling
Interests for further discussion of the
measurement requirements of ASC 480-10-S99-3A.
19
See Chapter 6 of Deloitte’s
Roadmap Noncontrolling Interests for further
discussion of attribution.
20
This entry has no impact on the
parent’s consolidated net income. However, it may
affect the amount of net income attributable to NCIs
on the face of the reporting entity’s consolidated
income statement as well as (directly or indirectly)
the amount of income available to the parent’s
common stockholders, which is the starting point for
the parent’s EPS calculation. The extent to which
this entry affects net income attributable to NCIs
and therefore net income attributable to the
parent’s common stockholders will depend on various
policies the reporting entity has elected for
classifying this entry, as described in Section
8.8.4.3.2.2.
21
These adjustments are recorded when
an NCI’s redemption price exceeds its ASC 810
carrying amount (i.e., its carrying amount after the
attribution of income or loss to the NCI). There are
two acceptable methods under ASC 480-10-S99-3A(15)
that may be applied to record a measurement
adjustment related to an NCI that is not currently
redeemable: the “accretion method” and the
“immediate method.” The immediate method is required
if the NCI is currently redeemable. See Table
8-7 for discussion of each method.
22
This amount reflects the
portion of an NCI’s redemption price that exceeds
the interest’s fair value.
23
This amount reflects the
portion of the ASC 480-10-S99-3A offsetting entry
arising from the portion of an NCI’s redemption
price that is equal to or less than fair value but
greater than the redeemable NCI’s ASC 810 carrying
amount.
24
The descriptions below assume that the subsidiary
only owns common stock of the parent. To the extent that the
subsidiary also has potential common shares in the parent, the
calculations of diluted EPS must take into account such ownership
interests, further complicating the EPS calculations.
8.9 Master Limited Partnerships
8.9.1 Background
ASC 260-10
Master Limited Partnerships
05-2 The Master Limited Partnerships Subsections clarify the application of the General Subsection of the Other Presentation Matters Subtopic to master limited partnerships.
05-3 Publicly traded master limited partnerships often issue multiple classes of securities that may participate in partnership distributions according to a formula specified in the partnership agreement. A typical master limited partnership consists of publicly traded common units held by limited partners, a general partner interest, and incentive distribution rights. Depending on the structure of the master limited partnership, the incentive distribution rights may be a separate class of nonvoting limited partner interest that the general partner initially holds but generally may transfer or sell apart from its overall interest. Alternatively, the incentive distribution rights may be embedded in the general partner interest such that they cannot be detached and transferred apart from the general partner’s overall interest.
05-4 Generally, the partnership agreement obligates the general partner to distribute 100 percent of the partnership's available cash (as defined in the partnership agreement) at the end of each reporting period to the general partner and limited partners via a distribution waterfall (that is, a schedule that prescribes distributions to the general partner and limited partners at each threshold) within a contractually determined period of time following the end of a reporting period. When certain thresholds are met, the distribution waterfall further allocates available cash to the holder of the separate class of nonvoting limited partner interest (the incentive distribution right holder) or, when the incentive distribution right is embedded in the general partner interest, to the general partner. The net income (or loss) of the partnership is allocated to the capital accounts of the general partner and limited partners based on their respective sharing of income or losses specified in the partnership agreement, but only after taking into account any priority income allocations resulting from incentive distributions.
05-5 Paragraphs 260-10-45-59A through 45–70 address the use of the two-class method to calculate earnings per unit for capital structures that are not convertible into a class of common stock.
An MLP is a publicly traded limited partnership that typically issues multiple
classes of securities that participate in partnership distributions in
accordance with distribution formulas stated in the partnership agreement. An
MLP combines the tax benefits of a limited partnership with the liquidity of
publicly traded securities.25 MLPs are often found in the energy industry but also exist in other
industries. A typical MLP consists of (1) publicly traded common units owned by
limited partners (LPs) (“common units”), (2) a general partner (GP) interest,
and (3) incentive distribution rights (IDRs). The common units generally
represent substantially all of the capital of the MLP. IDRs are not ownership
interests in the MLP, but they contain rights to share in the MLP’s
distributions. IDRs may be a separate class of nonvoting limited partnership
interests or may be embedded in the GP Interest. The GP is responsible for
managing the business operations of the MLP and receives a return for services
provided through management fees earned through the GP interest and
distributions received on IDRs.
The partnership agreement for an MLP obligates the GP to distribute 100 percent
of the partnership’s available cash, as defined in the partnership agreement, at
the end of each quarter to the LPs holding common units; to the GP; and when
certain thresholds are met, to the IDRs. These distributions are made via a
distribution waterfall (i.e., a schedule that prescribes distributions to the
LPs, GP, and IDRs at each threshold). The partnership agreement states that
holders of IDRs are not entitled to distributions other than as provided in the
distribution waterfall for available cash. The net income (or loss) of the
partnership is allocated to the capital accounts of the GP and LPs on the basis
of their ownership percentages, but only after taking into account any priority
income allocations to IDRs26 and losses previously allocated to the partners. Therefore, an investor’s
participation in the partnership’s distributions often does not mirror the
partnership’s allocation of the MLP’s income or losses to the investor’s capital
accounts.
Given the uniqueness of an MLP’s structure, ASC 260 contains specific guidance
on the calculation of EPU by MLPs.
8.9.2 Scope
ASC 260-10
Master Limited Partnerships
15-4 The Master Limited Partnership Subsections follow the same Scope and Scope Exceptions as outlined in the General Subsection of this Subtopic. See paragraphs 260-10-15-1 through 15-3, with specific qualifications noted in the following paragraph.
Entities
15-5 A master limited partnership may issue incentive distribution rights that are a separate class of nonvoting limited partner interest that the general partner initially holds or incentive distribution rights that are embedded in the general partner interest and therefore cannot be detached or transferred apart from the general partner’s overall interest. Incentive distribution rights that are a separate class of non-voting limited partner interest generally may be transferred or sold apart from the general partner interest. The Master Limited Partnership Subsections apply to all master limited partnerships that meet both of the following criteria:
- The partnership is required to make incentive distributions when certain thresholds have been met (regardless of whether the incentive distribution rights are a separate limited partner interest or embedded in the general partner interest)
- The partnership accounts for the incentive distributions as equity distributions (as opposed to compensation costs).
The determination of whether the incentive distribution is an equity distribution or compensation cost is outside the scope of the Master Limited Partnership Subsection.
ASC 260-10-15-4 and 15-5 address the scope of the specific EPU guidance applicable to MLPs. The general scope requirements of ASC 260 regarding the entities required to present EPS apply to MLPs. MLPs are subject to the requirement to present basic and diluted EPU in their financial statements because the common units issued to LPs meet the definition of common stock that trades in a public market.
SEC Considerations
The requirement for MLPs to present basic and diluted earnings per common unit is consistent with SAB Topic 4.F, which requires public limited partnerships to report the results of operations on a per-unit basis.
The specific EPU guidance in ASC 260 for MLPs focuses on how IDRs affect the EPU calculations. As discussed above, IDRs may be (1) a separate class of nonvoting limited partnership interest that is initially held by the GP but may be transferred or sold apart from the GP interest or (2) embedded in the GP interest in such a way that they may not be transferred or sold apart from this interest. As discussed in Section 8.9.3, this distinction affects whether the IDRs are considered participating securities and how the MLP applies the two-class method.
Connecting the Dots
The MLP subsection of ASC 260 only applies when
distributions on IDRs are considered equity distributions. In developing
the original pronouncement that was codified in the MLP subsection, the
EITF decided not to provide any EPU guidance related to situations in
which distributions on IDRs are considered compensation cost. The
determination of whether distributions on IDRs represent equity
distributions or compensation cost is a matter of professional judgment.
When distributions on IDRs are considered equity distributions, the
two-class method must be applied in the MLP’s calculation of EPU. When
distributions on IDRs are considered compensation cost, the IDRs are not
considered participating securities to which the two-class method must
be applied.
8.9.3 EPS Accounting
8.9.3.1 Guidance on Applying Two-Class Method to MLPs
ASC 260-10
Master Limited Partnerships
45-71 This Subsection provides guidance pertaining to the presentation of earnings per unit for master limited partnerships.
Incentive Distribution Rights That Are a Separate Class of Limited Partnership Interest
45-72 Incentive distribution rights that are a separate class of limited partner interest are participating securities because they have a right to participate in earnings with common equity holders. Therefore, current-period earnings shall be allocated to the general partner, limited partner, and incentive distribution right holder using the two-class method to calculate earnings per unit.
Incentive Distribution Rights That Are Embedded in the General Partner Interest
45-73 Incentive distribution rights that are embedded in the general partner interest are not separate participating securities. However, because the general partner and limited partner interests are separate classes of equity, the two-class method shall be applied in computing earnings per unit for the general partner and limited partner interests.
ASC 260 specifies that MLPs must apply the two-class method in calculating EPU,
regardless of whether the IDRs are in the form of a separate class of
limited partnership interest or are embedded in the GP interest. IDRs that
represent a separate limited partnership interest are participating
securities; therefore, the MLP should use the two-class method to allocate
current-period earnings to the common units, GP interest, and IDRs in
accordance with ASC 260-10-45-72. In contrast, IDRs that are embedded in the
GP interest do not represent separate participating securities.
Nevertheless, in such cases, the MLP would still use the two-class method to
allocate current-period earnings to the common units and GP interest
(including the IDRs) in accordance with ASC 260-10-45-73. The amount of
current-period earnings allocated to the IDRs would be included in the
amount of earnings allocated to the GP interest.
The following implementation guidance from ASC
260 helps explain the application of the two-class method of calculating EPU
for MLPs and includes separate discussion of IDRs that are participating
securities and those that are not:
ASC 260-10
Participating Securities and Undistributed Earnings
55-30 If a participating security provides the holder with the ability to participate in all dividends up to a specified threshold (for example, the security participates in dividends per common share up to 5 percent of the current market price of the stock), then undistributed earnings would be allocated to common stock and the participating security based on the assumption that all of the earnings for the period are distributed. In this example, undistributed earnings would be allocated to common stock and to the participating security up to 5 percent of the current market price of the common stock, as the amount of the threshold for participation by the participating security is objectively determinable. The remaining undistributed earnings for the period would be allocated to common stock.
Master Limited Partnerships
55-102 This Subsection, which is an integral part of the requirements of this Subtopic, provides general guidance used to compute earnings per unit for master limited partnerships.
Incentive Distribution Rights That Are a Separate Class of Limited Partner Interest
Distributions
55-103 When calculating earnings per unit under the two-class method for a master limited partnership, net income (or loss) for the current reporting period shall be reduced (or increased) by the amount of available cash that has been or will be distributed to the general partner, limited partners, and incentive distribution right holder for that reporting period. For example, assume a partnership agreement requires the general partner to distribute available cash within 60 days following the end of each fiscal quarter. The master limited partnership is required to file financial statements with a regulatory agency within 45 days following the end of each fiscal quarter. In order to compute earnings per unit for the first quarter, the general partner determines the amount of available cash that will be distributed to the general partner, limited partners, and incentive distribution right holder for that first quarter. The master limited partnership would reduce (or increase) net income (or loss) by that amount in computing undistributed earnings that are allocated to the general partner, limited partners, and incentive distribution right holder in calculating earnings per unit for the first quarter.
Earnings in Excess of Cash Distributions
55-104 Undistributed earnings shall be allocated to the general partner, limited partners, and incentive distribution right holder utilizing the contractual terms of the partnership agreement. The distribution waterfall (that is, a schedule that prescribes distributions to the various interest holders at each threshold) for available cash specified in the partnership agreement contractually mandates the way in which earnings are distributed for the period presented. The undistributed earnings shall be allocated to the incentive distribution right holder based on the contractual participation rights of the incentive distribution right to share in current period earnings. Therefore, if the partnership agreement includes a specified threshold as described in paragraph 260-10-55-30, a master limited partnership shall not allocate undistributed earnings to the incentive distribution right holder once the specified threshold has been met.
55-105 In determining whether a specified threshold exists, a master limited partnership shall evaluate whether distributions to the incentive distribution right holder would be contractually limited to available cash as defined in the partnership agreement if all earnings for the period were distributed. For example, if the partnership agreement contractually limits distributions to the incentive distribution right holder to the holder’s share of available cash as defined in the partnership agreement, then the specified threshold for the current reporting period would be the holder’s share of available cash that has been or will be distributed for that reporting period. The master limited partnership would not allocate undistributed earnings to the incentive distribution right holder because the holder’s share of available cash is the maximum amount that the incentive distribution right holder would be contractually entitled to receive if all earnings for the current reporting period were distributed. However, if the partnership agreement is silent or does not explicitly limit distributions to the incentive distribution right holder to available cash, then the master limited partnership would allocate undistributed earnings to the incentive distribution right holder utilizing the distribution waterfall for available cash specified in the partnership agreement.
Cash Distributions in Excess of Earnings
55-106 Any excess of distributions over earnings shall be allocated to the general partner and limited partners based on their respective sharing of losses specified in the partnership agreement (that is, the provisions for allocation of losses to the partners’ capital accounts for the period presented). If the incentive distribution right holders do not share in losses, the excess of distribution over earnings amount would not be allocated to the incentive distribution right holders. However, if the incentive distribution right holders have a contractual obligation to share in the losses of the master limited partnership on a basis that is objectively determinable (as described in paragraph 260-10-45-68), the excess of distributions over earnings shall be allocated to the general partner, limited partners, and incentive distribution right holders based on their respective sharing of losses specified in the partnership agreement for the period presented.
Incentive Distribution Rights That Are Embedded in the General Partner Interest
Distributions
55-107 When calculating earnings per unit under the two-class method for a master limited partnership, net income (or loss) for the current reporting period shall be reduced (or increased) by the amount of available cash that has been or will be distributed to the general partner (including the distribution rights of the embedded incentive distribution rights) and limited partners for that reporting period. For example, assume that a partnership agreement requires the general partner to distribute available cash within 60 days following the end of each fiscal quarter. The master limited partnership is required to file financial statements with a regulatory agency within 45 days following the end of each fiscal quarter. In order to compute earnings per unit for the first quarter, the general partner determines the amount of available cash that will be distributed to the general partner and limited partners for that first quarter. The master limited partnership would reduce (or increase) net income (or loss) by that amount in computing undistributed earnings that are allocated to the general partner (including the distribution rights of the embedded incentive distribution rights) and limited partners in calculating earnings per unit for the first quarter.
Earnings in Excess of Cash Distributions
55-108 Undistributed earnings shall be allocated to the general partner (including the distribution rights of the embedded incentive distribution rights) and limited partners utilizing the contractual terms of the partnership agreement. The distribution waterfall for available cash specified in the partnership agreement contractually mandates the way in which earnings are distributed for the period presented. The undistributed earnings shall be allocated to the general partner (with respect to the distribution rights of an embedded incentive distribution right) based on the contractual participation rights of the incentive distribution right to share in current period earnings. Therefore, if the partnership agreement includes a specified threshold as described in paragraph 260-10-55-30, a master limited partnership shall not allocate undistributed earnings to the general partner (with respect to the distribution rights of an embedded incentive distribution right) once the specified threshold has been met.
55-109 In determining whether a specified threshold exists, a master limited partnership shall evaluate whether distributions to the general partner (with respect to the distribution rights of an embedded incentive distribution right) would be contractually limited to available cash as defined in the partnership agreement if all earnings for the period were distributed. For example, if the partnership agreement contractually limits distributions to the general partner (with respect to the distribution rights of an embedded incentive distribution right) to the holder’s share of available cash as defined in the partnership agreement, then the specified threshold for the current reporting period would be the general partner’s share (with respect to the distribution rights of an embedded incentive distribution right) of available cash that has been or will be distributed for that reporting period. The master limited partnership would not allocate undistributed earnings to the general partner (with respect to the distribution rights of an embedded incentive distribution right) because the general partner’s share (with respect to the distribution rights of an embedded incentive distribution right) of available cash is the maximum amount that the general partner (with respect to the distribution rights of an embedded incentive distribution right) would be contractually entitled to receive if all earnings for the current reporting period were distributed. However, if the partnership agreement is silent or does not explicitly limit distributions to the general partner (with respect to the distribution rights of an embedded incentive distribution right) to available cash, then the master limited partnership would allocate undistributed earnings to the general partner (with respect to the distribution rights of an embedded incentive distribution right) utilizing the distribution waterfall for available cash specified in the partnership agreement.
Cash Distributions in Excess of Earnings
55-110 Any excess of distributions over earnings shall be allocated to the general partner and limited partners based on their respective sharing of losses specified in the partnership agreement for the period presented.
The following is a summary of the guidance in ASC 260-10-55-102 through 55-110 on an MLP’s calculation of EPU under the two-class method:
- IDR is separate class of limited partnership interest — The MLP’s earnings are allocated among the common units, GP interest, and IDRs by using the two-class method, and the IDRs are considered a participating security. Distributed earnings for each quarterly financial reporting period will equal available cash (as defined in the MLP’s partnership agreement) for that specific period, even though the actual distributions do not occur until the following quarterly financial reporting period. That is, the amount of available cash that is considered to represent distributed earnings must be based on the portion of the respective financial reporting period’s earnings that must be distributed in the following period. Undistributed earnings for each quarterly financial reporting period, which represent net income of the MLP less distributed earnings, should be allocated to the common units, GP interest, and IDRs on the basis of the contractual terms of the partnership agreement. If the MLP contains a specified threshold, as described in ASC 260-10-55-30, the MLP would not allocate undistributed earnings to the IDRs once the specified threshold is met. As a result, the undistributed earnings would be allocated only to the common units and the GP interest. Any excess of cash distributed over earnings would be allocated to the IDRs (along with the common units and GP interest) only if the IDRs contain a contractual obligation to share in losses, which will typically not be the case. Therefore, cash distributions that exceed earnings, or undistributed losses, will typically not be allocated to IDRs.
- IDR is embedded in the GP interest — The MLP’s earnings are allocated among the common units and GP interest (including the distribution rights of the IDRs) by using the two-class method. Distributed earnings for each quarterly financial reporting period will equal available cash (as defined in the MLP’s partnership agreement) for that specific period, even though the actual distributions do not occur until the following quarterly financial reporting period. That is, the amount of available cash that is considered as representing distributed earnings must be based on the portion of the respective financial reporting period’s earnings that must be distributed in the following period. Undistributed earnings for each quarterly financial reporting period, which represent net income of the MLP less distributed earnings, should be allocated to the common units and GP interest (including the distribution rights of the IDRs) on the basis of the contractual terms of the partnership agreement. If the MLP contains a specified threshold, as described in ASC 260-10-55-30, the MLP would not allocate undistributed earnings to the GP interest with respect to distribution rights of the IDRs once the specified threshold is met. As a result, the undistributed earnings would be allocated only to the common units and GP interest (excluding the distribution rights of the IDRs). Any excess of cash distributed over earnings would be allocated to common units and GP interest on the basis of their respective sharing of losses in the partnership agreement for the MLP.
Connecting the Dots
Under the MLP subsection of ASC 260, the calculation of EPU by an MLP critically
depends on whether the partnership agreement contains a specified
threshold under ASC 260-10-55-30. ASC 260 indicates that the
partnership agreement for an MLP contains a specified threshold if
distributions on IDRs (or the GP interest with respect to
distribution rights of embedded IDRs) are contractually limited to
the IDR’s allocable portion of available cash, as defined in the
partnership agreement. Thus, the determination of whether
undistributed earnings are allocated to IDRs is not based on an
assumption that cash available for distribution equals net earnings
for the period (or that all earnings for the period are
distributed). Rather, the focus is on whether a specified threshold
exists, as discussed in ASC 260. Since this guidance is specific to
MLPs, it should not be applied by analogy.
In practice, most MLP partnership agreements will contractually limit distributions to available cash and a specified threshold therefore will exist. As a result, the MLP should not allocate undistributed earnings to the IDRs (or the GP interest with respect to the distribution rights of an embedded IDR). Rather, undistributed earnings are allocated only to the common units and GP interest (excluding any distribution rights of an embedded IDR). ASC 260 does not provide any specific guidance on how to allocate undistributed earnings (or losses) to common units and the GP interest. The allocation based on the waterfall in the allocation of available cash is not appropriate unless it is modified to exclude the waterfall provisions associated with allocations to IDRs. Therefore, the MLP would need to apply an allocation based on (1) the waterfall for the allocation of available cash as modified to exclude IDRs (i.e., as if the IDRs did not exist), (2) a capital allocation approach, (3) a relative percentage ownership approach, or (4) another systematic and rational method. The objective of the allocation approach selected should be to mirror how undistributed earnings (losses) would be allocated if undistributed earnings (or losses) were distributed. The method of allocation selected should be applied consistently.
In the unusual circumstance in which a partnership agreement for an MLP does not contain a specified threshold, the two-class method should be applied under an assumption that all earnings for the period are distributed, which will result in an allocation of undistributed earnings to IDRs (or the GP interest with respect to the distribution rights of an embedded IDR). The allocation of undistributed earnings should be based on the contractual waterfall of distributions of the partnership under the assumption that distributions pertaining to the period equaled net earnings for the period. Because IDRs typically do not contractually share in losses, undistributed losses would typically not be allocated to IDRs.
8.9.3.2 Examples of Application of Two-Class Method to MLPs
8.9.3.2.1 IDR Is Separate Class of Limited Partnership Interest and Earnings Exceed Available Cash
The example below illustrates the calculation of the two-class method for
calculating EPU for an MLP when the IDRs are a separate class of limited
partnership interest and the earnings of the MLP for the period exceed
available cash.
Example 8-29
Assume the following:
- Partnership A has net income of $50,000 for the quarter ended March 31, 20X1.
- Partnership A has 9,800 common units held by the LPs (the “common units”), 200 GP units, and IDRs.
- On March 31, 20X1, A has available cash, as defined in the partnership agreement, of $20,000.
- The waterfall requires that available cash be distributed as follows:
- First, 98 percent to the LPs and 2 percent to the GP until each LP has received a total of $0.40 per LP common unit (the “first threshold”), with 98 percent and 2 percent representing the ownership percentages of the LPs and GP, respectively.
- Second, 85 percent to the LPs, 2 percent to the GP, and 13 percent to the IDRs until each LP has received a total of $0.50 per LP common unit (the “second threshold”).
- Third, 75 percent to the LPs, 2 percent to the GP, and 23 percent to the IDRs until each LP has received a total of $0.60 per LP common unit (the “third threshold”).
- Thereafter, 50 percent to the LPs, 2 percent to the GP, and 48 percent to the IDRs.
- The following table illustrates the cumulative amount of available cash that would be distributed to the LPs, the GP, and the IDRs at each threshold.
Partnership A would apply the two-class method of calculating EPU. The
application would depend on whether the
partnership agreement contractually limits
distributions to IDRs to the allocable portion of
available cash and, as a result, contains a
“specified threshold,” as described in ASC
260-10-55-30. Whether the partnership agreement
contains a specified threshold is a matter of
professional judgment. However, if the partnership
agreement is silent on this matter or does not
explicitly limit distributions to the IDR holders
of available cash, the partnership agreement would
not be considered to have a specified
threshold.
Calculation of EPU — Specified Threshold Exists
If the partnership agreement is considered to have a “specified threshold,” the partnership would allocate available cash to the LP common units, the GP units, and the IDRs by using the distribution waterfall specified in the partnership agreement. The undistributed earnings are allocated to the LP common units and the GP units only according to the contractual terms of the partnership agreement (which, for this example, is assumed to be based on the LPs’ and the GP’s ownership percentages).
Calculation of EPU — Specified Threshold Does Not Exist
If the partnership agreement is not considered to have a “specified threshold,” the partnership would allocate current-period earnings to the LP common units, the GP units, and the IDRs by using the distribution waterfall specified in the partnership agreement. That is, because the two-class method requires that current-period earnings be allocated as though all the earnings have been distributed, current-period earnings would be viewed as the amount of cash available for distribution. Therefore, in this example, an entity would use the distribution waterfall to allocate the undistributed earnings of $30,000 to the LP common units, the GP units, and the IDRs.
8.9.3.2.2 IDR Is Separate Class of Limited Partnership Interest and Available Cash Exceeds Earnings
The example below illustrates the use of the two-class method to calculate EPU
for an MLP when the IDRs are a separate class of limited partnership
interest and the available cash of the MLP for the period exceeds
earnings.
Example 8-30
Assume the same facts as in Example 8-29 except that on March 31,
20X1, Partnership A has available cash of
$70,000.
Calculation of EPU — IDRs Do Not Have Contractual Obligation to Share in Losses
Partnership A must determine whether, under the partnership agreement, the IDR holders have a contractual obligation to share in the losses of the partnership on a basis that is objectively determinable. If the IDR holders do not have a contractual obligation to share in losses, the excess of distributions over earnings is allocated to the LP common units and the GP units on the basis of their respective sharing of losses specified in the partnership agreement (which, in this example, are assumed to be shared between the LPs and the GP on the basis of their contractual ownership percentages).
The following are the calculations of the IDR, GP unit, and LP common unit
distribution amounts (as described in the first
table footnote above) by using the waterfall table
from Example 8-29,
updated for $70,000 in cash available (versus
$20,000 in Example
8-29).
-
GP units: ($70,000 available cash – $6,459.61 total third threshold amount) × 2% + $129.19 GP third threshold amount = $1,400.
-
IDRs: ($70,000 available cash – $6,459.61 total third threshold amount) × 48% + $450.42 IDR third threshold amount = $30,949.80.
-
LP common units: ($70,000 available cash – $6,459.61 total third threshold amount) × 50% + $5,880 LP third threshold amount = $37,650.20.
Calculation of EPU — IDRs Do Have a Contractual
Obligation to Share in Losses
If the IDR holders do have a contractual obligation to share in losses, the excess of distributions over earnings is allocated to the LP common units, the GP units, and the IDRs on the basis of their respective sharing of losses specified in the partnership agreement. Assume that the IDRs share in losses in the same manner as they share in earnings (i.e., via the distribution waterfall, which, for this example, is equal to the undistributed losses).
8.9.4 Drop-Down Transaction
ASC 260-10
Prior-Period Adjustments
55-16A See paragraph 260-10-55-111 for guidance on the presentation of prior-period earnings per unit for entities within the scope of the Master Limited Partnerships Subsections that retrospectively adjust their financial statements and financial information for prior periods as a result of a dropdown transaction accounted for under the Transactions Between Entities Under Common Control Subsections of Subtopic 805-50.
Presentation of Historical Earnings per Unit After a
Dropdown Transaction Accounted for as a
Transaction Between Entities Under Common
Control
55-111 A general partner may transfer net assets to a master limited partnership as part of a dropdown transaction that occurs after formation of the master limited partnership. If the master limited partnership accounts for the dropdown transaction under the Transactions Between Entities Under Common Control Subsections of Subtopic 805-50, in calculating the historical earnings per unit under the two-class method, the earnings (losses) of the transferred net assets before the date of the dropdown transaction should be allocated entirely to the general partner. In that circumstance, the previously reported earnings per unit of the limited partners for periods before the date of the dropdown transaction should not change as a result of the dropdown transaction.
The following example helps illustrate the
accounting for a drop-down transaction:
Example 8-31
Accounting for Drop-Down Transaction
Assume the following:
- Partnership A, an MLP, originally reported net income of $200,000 for the years ended December 31, 20X2, and 20X1.
- On January 1, 20X3, A’s GP enters into a drop-down transaction between entities under common control by transferring certain net assets to A in exchange for cash. The net income of the transferred net assets was $20,000 for the years ended December 31, 20X2, and 20X1.
- According to the partnership agreement for A, net income is allocated to the GP and LPs on the basis of their ownership percentages (2 percent to GP, 98 percent to LPs).
- For simplicity, there are no equity interests outstanding for A other than the GP and LP interests.
Partnership A originally reported income and EPU for the years ended December 31, 20X2, and 20X1 as follows:
After the drop-down transaction, A must retrospectively adjust its financial
statements for prior reporting periods in accordance
with ASC 260-10-55-16A. Under ASC 260-10-55-111, the
previously reported EPU of the LPs should not change as
a result of the drop-down transaction. Therefore, the
retrospectively adjusted net income must be allocated to
the GP and the previously reported income attributable
to the LPs is not adjusted. The income and EPU for the
years ended December 31, 20X2, and 20X1 would be
adjusted as follows.
In accordance with ASC 260-10-50-3, A should disclose that the GP was entitled
to 100 percent of the income of the transferred assets
before the date of the drop-down transaction and that
the GP and LPs had the right to 2 percent and 98
percent, respectively, of income after the drop-down
transaction for the purpose of subsequent calculations
of EPU under the two-class method going forward. See
Section 9.2.1.2 for information about
the disclosure requirements related to drop-down
transactions.
Footnotes
25
A major advantage of investing in an MLP is that
distributions are typically classified as pass-through income and the
partnership itself is not subject to corporate taxation on income.
Income is taxed on the individual investor on the basis of the
distributions received from the MLP.
26
These priority allocations equal the cash distributions
on IDRs, so the capital account for the IDRs maintains a zero balance
over the life of the MLP.
8.10 R&D Arrangements
ASC 810-30 addresses R&D arrangements in which all of the funds for the
R&D activities are provided by sponsors of
such arrangements. For this purpose, a sponsor is
defined as an entity that capitalizes an R&D
arrangement in return for a common stock interest
in the R&D entity. For instance, ASC 810-30
discusses a transaction in which a sponsor
capitalizes a new entity with cash, as well as
rights to certain technology developed by the
sponsor, in exchange for Class A and Class B
common stock in the new entity. The Class B common
stock conveys essentially no financial interest to
the sponsor and, other than certain blocking
rights, provides the sponsor with essentially no
voting rights. The sponsor subsequently
distributes the Class A common stock to its
shareholders in accordance with a purchase option
held by the sponsor. The sponsor then receives
funds from the new entity to perform R&D
activities.
ASC 810-30 specifies the sponsor’s accounting for the specific transaction described above. ASC 810-30-45-2 states that the R&D expense recognized by the sponsor for this arrangement should not be allocated to the new entity’s Class A common stock in the determination of net income or income available to the sponsor’s common stockholders in its calculation of EPS.