Deloitte's Roadmap: Earnings per Share
Preface
Preface
We are pleased to present the 2023 edition of Earnings per
Share. This Roadmap provides an overview of the accounting and disclosure
guidance in ASC 2601 as well as insights into and interpretations of how to apply the guidance in
practice. In addition, the discussion is accompanied by excerpts from the related
authoritative text.
The calculation of EPS is a complex aspect of GAAP that is largely
governed by “rules-based” guidance developed over many years in response to requests
by constituents for interpretive guidance on certain narrow issues. The impact that
specific transactions or instruments have on EPS is often viewed as not necessarily
reflecting the economics of such transactions or instruments. Such complexity
affects preparers as well as users.
The 2023 update of this Roadmap contains new and expanded guidance on certain matters
related to calculating basic and diluted EPS. Note that in this edition, it is
assumed that an entity has already adopted ASU 2020-06 and ASU 2021-04. For a
listing of significant changes made since the issuance of the 2022 edition of this
publication, see Appendix F.
Be sure to check out On the
Radar (also available as a stand-alone publication),
which briefly summarizes emerging issues and trends related
to the accounting and financial reporting topics addressed
in the Roadmap.
We hope you find this Roadmap useful in navigating the EPS
accounting and disclosure guidance, reducing complexity, and arriving at appropriate
accounting conclusions. In addition, we welcome your suggestions for future
improvements to the publication. If you need assistance with applying the guidance
or have other questions about this topic, we encourage you to consult with our
technical specialists and other professional advisers.
Footnotes
1
For a list of abbreviations used in this publication, see
Appendix E.
For the full titles of standards, topics, and regulations used in this
publication, see Appendix
D.
On the Radar
On the Radar
EPS is one of the most prominent financial ratios analyzed by
financial statement users. The objective of EPS is to measure the performance of an
entity over a financial reporting period. EPS must be presented by entities that (1)
have common stock that trades in a public market or (2) file with a regulatory
agency for the sale of common stock in a public market. ASC 260 addresses the
calculation, presentation, and disclosure of EPS.
Entities that present EPS must
provide two metrics:
Many entities also disclose non-GAAP EPS amounts (e.g., diluted EPS adjusted to
exclude certain charges or gains). SEC registrants may generally disclose non-GAAP
EPS amounts as long as they comply with SEC Regulation S-K, Item 10(a), as
interpreted by the SEC staff. Such disclosures must be meaningful, reconciled to
GAAP EPS, and not shown with more prominence than GAAP EPS.
The SEC staff closely scrutinizes non-GAAP measures that
are included in press releases, Form 8-K filings, and
other filings under the Securities Act and Exchange Act
and will challenge non-GAAP EPS amounts that do not
comply with SEC Regulation S-K, Item 10(a). For example,
the disclosure of EBIT or EBITDA per share or per-share
amounts that are liquidity measures is
prohibited.
Basic EPS
The calculation of basic EPS is straightforward for entities with simple capital
structures. Basic EPS equals net income or loss divided by the weighted-average
number of shares of common stock outstanding during the period. Outstanding
common stock includes issued common shares that are not subject to any vesting
conditions and shares issuable for little or no consideration. Outstanding
common stock does not include shares held in treasury or contingently issuable
shares.
Certain complexities that can arise when basic EPS is calculated
are discussed in the sections below.1
Dividends on Preferred Stock
Dividends on preferred stock reduce net income (or increase
net loss) to arrive at income (or loss) available to common stockholders,
which is the numerator in the calculation of basic EPS. Such dividends
include (1) dividends that accumulate on cumulative preferred stock; (2)
dividends that are declared on noncumulative preferred stock; (3) the
accretion of dividends on convertible preferred stock with an increasing
rate; (4) undistributed earnings attributable to participating preferred
stock; and (5) “deemed” dividends such as exercise price adjustments
triggered by down-round features and measurement adjustments on redeemable
preferred stock.
Noncontrolling Interests
The numerator in the calculation of basic EPS reflects only
net income or loss of the parent; therefore, income or loss attributable to
noncontrolling interests (NCIs) must be excluded. Accordingly, an entity
must calculate basic EPS at the subsidiary level and use that amount in
calculating the parent’s EPS.
Redeemable Securities
SEC registrants are required to present redeemable securities, such as
redeemable preferred stock, common stock, share-based payment arrangements,
and NCIs, within temporary equity. In addition, an entity may be required to
remeasure the carrying amount of such securities to their redemption amount.
Such measurement adjustments are treated as “deemed dividends” that may
result in an adjustment to the numerator in the calculation of basic
EPS.
Participating Securities
The ASC master glossary defines a participating security as a “security that
may participate in undistributed earnings with common stock, whether that
participation is conditioned upon the occurrence of a specified event or
not.” Participating securities may include debt instruments, preferred stock
instruments, contracts on an entity’s own equity, share-based payment
arrangements, and NCIs. An entity with participating securities must
allocate a portion of undistributed net income to such securities in
accordance with the two-class method of calculating EPS. Such allocation
will result in a reduction of basic EPS because the common stockholders are
not entitled to share in all of the entity’s earnings.
The
determination of whether an instrument is a
participating security and the use of the
two-class method of calculating EPS are two of the
most complicated aspects of applying ASC 260.
Entities may need to consult with their accounting
advisers to appropriately apply ASC 260.
Multiple Classes of Common Stock
Entities that have multiple classes of common stock and master limited
partnerships (MLPs) must apply the two-class method of calculating basic EPS
to present EPS for each class. An entity has more than one class of common
stock if some, but not all, of its common shares are redeemable.
Modifications of Securities
When an entity modifies preferred stock or a contract on its
own equity and the fair value of the instrument increases as a result of the
modification, a charge to the numerator in the calculation of EPS may be
required if the modification includes a “deemed dividend.” A modification of
common stock could also affect the numerator in the calculation of basic
EPS.
Redemptions of Securities
ASC 260-10-S99-2 requires entities to adjust the numerator in the calculation
of basic EPS for the difference between the fair value of the consideration
transferred and the carrying amount of preferred stock that is redeemed or
otherwise considered extinguished. The numerator may also need to be
adjusted when common stock is repurchased for more than fair value.
Conversions of Preferred Stock
Certain conversions of preferred stock into common stock affect the numerator
in the calculation of basic EPS. ASC 260-10-S99-2 requires an entity to
adjust the numerator for the excess value conveyed in an induced conversion
of preferred stock. In addition, when preferred stock that contains a
separately recognized equity component or embedded conversion option
liability is converted into common stock, an entity may be required to
recognize an adjustment to the numerator for a “deemed dividend” that occurs
upon such conversion.
Changes in Capital Structure
When stock dividends, stock splits, and certain rights issues exist, entities
must retrospectively adjust previously reported basic EPS to reflect the
change in outstanding common shares. Other changes in capital structure may
be treated similarly or may be reflected only prospectively. Significant
judgment is often required when there is a change in an entity’s capital
structure.
Other
Other situations that affect the calculation of basic EPS include
prior-period adjustments, certain issuances of common stock, accelerated
share repurchase agreements, own-share lending arrangements, business
combinations, discontinued operations, and equity method investees.
Diluted EPS
Diluted EPS is a per-share performance measure that includes (1) outstanding
common shares and (2) additional common shares that would have been outstanding
if the dilutive potential common shares had been issued. In calculating diluted
EPS, an entity assumes that all dilutive potential common shares within its
capital structure were outstanding during the reporting period and that net
income (the numerator) was calculated by using a consistent assumption. To
determine whether a potential common share is dilutive, entities must apply the
antidilution sequencing guidance in ASC 260, which often proves difficult. The
complexity of calculating diluted EPS will vary depending on the nature of an
entity’s capital structure.
To calculate diluted EPS, an entity makes various adjustments to the numerator
and denominator in the calculation of basic EPS to reflect the impact of
potential common shares. To do so, the entity uses one of four methods — the
treasury stock method, the reverse treasury stock method, the if-converted
method, or the contingently issuable share method.
In calculating diluted EPS, an entity
must adjust the numerator for convertible
instruments and other contracts whose accounting
classification differs from their EPS treatment
(e.g., contracts classified as assets or liabilities
that are considered share-settled for diluted EPS
purposes). Entities with more complex capital
structures may also need to apply the two-class
method of calculating diluted EPS.
The graphic below illustrates the types of adjustments to the numerator and
denominator that an entity may be required to make when calculating diluted
EPS.
Treasury Stock Method
The treasury stock method is an approach to calculating diluted EPS in which
an entity assumes that the proceeds that would be obtained upon the exercise
of options, warrants, and similar instruments are used to purchase common
stock at the average market price during the period. The excess of the
shares issuable over the shares repurchased is added to the denominator. An
adjustment to the numerator is also necessary for contracts classified as
assets or liabilities since they are considered to be equity-classified for
diluted EPS purposes.
Reverse Treasury Stock Method
The reverse treasury stock method is an approach to calculating diluted EPS
in which an entity assumes that the proceeds needed to satisfy an obligation
to repurchase common stock (i.e., a put option or forward contract) will be
raised by issuing shares at the average market price during the period. The
excess of the shares issuable over the shares repurchased is added to the
denominator. An adjustment to the numerator is also necessary because
contracts subject to the reverse treasury stock method are classified as
assets or liabilities for accounting purposes.
If-Converted Method
The if-converted method is an approach to calculating
diluted EPS in which conversion of convertible securities at the beginning
of the reporting period (or at the time of issuance, if later) is assumed.
To apply the if-converted method, an entity generally must also adjust the
numerator.
Contingently Issuable Share Method
The contingently issuable share method is an approach to calculating diluted
EPS in which an entity assumes that the number of common shares that would
be issued, if any, if the reporting period was the end of the contingency
period, are issued and outstanding. An adjustment to the numerator is also
necessary for contingently issuable share arrangements that are classified
as assets or liabilities.
In the guidance in ASC 260 on diluted EPS, it is assumed that the calculation
is performed on an interim reporting basis. As a result, ASC 260 contains
additional guidance on how to calculate diluted EPS on a year-to-date basis.
In performing such calculations, entities must use the numerator and
denominator amounts in the individual interim-period calculations.
Presentation and Disclosure
ASC 260 requires entities to present basic and diluted EPS with equal prominence
on the face of the income statement for each period presented. Under ASC 270-10,
the same requirement applies to interim periods. Entities with multiple classes
of common stock must present basic and diluted EPS for each class on the face of
the income statement. Entities that report a discontinued operation must present
basic and diluted EPS on the face of the income statement for income (loss) from
continuing operations and net income (loss).
SEC Regulation S-X outlines the format and content
required in financial reports filed with the SEC,
including the presentation of EPS in annual reports
and interim reports filed under the Exchange
Act.
ASC 260 requires entities to provide a number of disclosures about EPS. SEC
registrants must also furnish the incremental disclosures required by the SEC’s
rules and guidance. In some situations, entities must disclose pro forma EPS
amounts (i.e., as required by GAAP or the SEC’s rules and guidance). SEC
Regulation S-X, Article 11, provides guidance on preparing pro forma financial
information.
Entities that disclose per-share measures not required
by ASC 260 or other Codification topics, including,
but not limited to, non-GAAP EPS amounts, should
exercise caution because the SEC staff often
challenges the appropriateness or usefulness of such
measures.
This Roadmap comprehensively addresses
the calculation, presentation, and disclosure of
EPS.
Footnotes
1
Because diluted EPS is calculated on the basis of basic
EPS, these matters also affect the calculation of diluted EPS. However,
certain considerations that apply to diluted EPS are not relevant to the
calculation of basic EPS.
Contacts
Contacts
|
Ashley Carpenter
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3197
|
|
Jonathan Howard
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3235
|
If you are interested in Deloitte’s
EPS service offerings, please contact:
|
Jamie Davis
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 312 486 0303
|
Chapter 1 — Overview
Chapter 1 — Overview
1.1 Introduction
This Roadmap discusses the calculation, presentation, and disclosure of EPS in
an entity’s financial statements. Under ASC 260,
entities are required to present or disclose basic
EPS and diluted EPS amounts for income from
continuing operations, income from discontinued
operations, and net income for each class of
common stock for each financial reporting period
presented. Basic EPS is calculated as income
available to common stockholders divided by the
weighted-average number of common shares
outstanding, and diluted EPS includes potential
common stock that, if actually issued, would
dilute basic EPS.
Section 1.2 is a brief history of the
EPS-related standards that were issued before the codification of the current
guidance in ASC 260.
1.2 History of EPS Guidance
In 1969, the AICPA issued Opinion 15, the purpose of which was to
ensure that EPS information was “computed on a consistent basis and presented in the
most meaningful manner.” As discussed in Opinion 15, before entities were required
to present EPS information, EPS data were commonly used “in evaluating the past
operating performance of a business, in forming an opinion as to its earnings
potential and in making investment decisions.” Further, such data were commonly
presented in “prospectuses, proxy material, and reports to stockholders.”
After the AICPA issued numerous accounting interpretations related
to the application of Opinion 15, domestic and international standard setters began
to pursue the convergence of their accounting standards on EPS. The International
Accounting Standards Committee (IASC) issued a statement of principles on EPS in
1993 to provide an appropriate framework under which EPS data of entities globally
can be calculated.
In the years after the issuance of the IASC’s statement of
principles on EPS, the FASB and IASC worked together to initiate a consistent
international approach to the determination and subsequent presentation of EPS.
Because the rules and regulations of foreign jurisdictions varied with respect to
determining earnings, the diversity in international practice in this area was not
the focus of the convergence efforts. Rather, the FASB and IASC believed that a
consistently determined denominator would help significantly improve EPS
comparability for entities globally. Thus, much of the standard setting at this time
focused on developing a consistent framework for determining the denominator in the
computation of EPS.
In 1997, the FASB and IASC concurrently issued Statement 128 and IAS 33, respectively; the guidance in these EPS standards was substantially converged. Since the issuance of Statement 128, the FASB’s Emerging Issues Task Force (EITF) has deliberated and reached consensus on a number of specific EPS topics. The guidance in Statement 128 and in these subsequent interpretations is codified in ASC
260. In addition, the FASB has issued several ASUs to amend the EPS guidance in ASC
260.
The FASB and International Accounting Standards Board
(IASB®) have not fully converged their accounting guidance on the
presentation and disclosure of EPS. See Appendix A for a table comparing the EPS
guidance in U.S. GAAP with that in IFRS® Accounting Standards.
1.3 Recent Changes in EPS Guidance
In August 2020, the FASB issued ASU
2020-06, which simplifies the accounting for
convertible instruments and equity-linked financial instruments in
addition to amending the EPS guidance in ASC 260. Significant
amendments that ASU 2020-06 makes to the EPS guidance include the
following:
- All convertible instruments not issued at a substantial premium, and for which the embedded conversion option does not need to be bifurcated under ASC 815-15, constitute a single unit of account. Therefore, the numerator in the calculation of EPS is no longer affected by beneficial conversion features or the amortization of debt discounts on convertible instruments previously accounted for under the cash conversion subsections of ASC 470-20.
- The if-converted method applies to the calculation of diluted EPS for all convertible instruments. The ASU modifies the use of the if-converted method for convertible debt instruments for which the principal amount must be settled in cash upon conversion, requiring entities to calculate diluted EPS in a manner consistent with the application of the treasury stock method.
- Entities cannot overcome the presumption of share settlement for contracts that may be settled in cash or stock. However, one exception is provided for share-based payment awards that are classified as liabilities.
- An average share price must be used to calculate the impact on diluted EPS for instruments for which the entity’s share price may affect (1) the exercise price of the instrument or (2) the number of shares that may be issued to settle the instrument.
- The numerator in the calculation of basic EPS should be adjusted to reflect the value of a down-round feature in an equity-classified freestanding financial instrument or an equity-classified preferred stock instrument when the down-round feature is triggered. An entity would not adjust the numerator when a down-round feature is triggered in a convertible debt instrument.
- When an entity must adjust the numerator to remove the earnings effect of the change in fair value of an asset or liability that is presumed to be share-settled for EPS purposes, the number of incremental shares included in the denominator of a year-to-date EPS would be calculated on the basis of the year-to-date weighted average of the number of incremental shares included in each calculation of diluted EPS on a quarterly basis.
Further, the FASB also issued ASU 2021-04 in May
2021, to address an issuer’s accounting for certain modifications or
exchanges of freestanding equity-classified written call options.
See Section
3.2.6.4 for more information about the accounting
for modifications or exchanges of freestanding equity-classified
written call options.
In this Roadmap, it is assumed that an entity has
adopted both ASU 2020-06 and ASU 2021-04.
In addition to the FASB guidance discussed above, other recent guidance that
affects EPS includes the SEC’s (1) May 2020 Final Rule
33-10786 (see Section B.1), which
changes the pro forma presentation and disclosure requirements,
including those related to pro forma EPS, and (2) November 2020
Final
Rule 33-10890, which amends SEC Regulation
S-X (the guidance in this rule affects various chapters of this
Roadmap).
Chapter 2 — Scope
Chapter 2 — Scope
2.1 General
ASC 260-10
Entities
15-2 The guidance in the
Earnings per Share Topic requires presentation of earnings
per share (EPS) by all entities that have issued common
stock or potential common stock (that is, securities such as
options, warrants, convertible securities, or contingent
stock agreements) if those securities trade in a public
market either on a stock exchange (domestic or foreign) or
in the over-the-counter market, including securities quoted
only locally or regionally. This Topic also requires
presentation of EPS by an entity that has made a filing or
is in the process of filing with a regulatory agency in
preparation for the sale of those securities in a public
market.
15-3 The guidance in this Topic does not require presentation of EPS for investment companies that comply with the requirements of Topic 946 or in statements of wholly owned subsidiaries. Any entity that is not required to present EPS in its financial statements that chooses to present EPS in its financial statements shall do so in accordance with the provisions of this Topic.
ASC 260 establishes guidance on calculating and presenting EPS related to common
stock and potential common stock. As noted above in ASC 260-10-15-2 and 15-3, when
the following two conditions are met, an entity other than an investment company is
required to present EPS in its financial statements:
-
The entity has outstanding common stock or potential common stock.
-
The entity’s common stock or potential common stock trades “in a public market” or the entity “has made a filing or is in the process of filing with a regulatory agency in preparation for the sale of [common stock or potential common stock] in a public market.”
Entities subject to ASC 260 must present or disclose, for each financial reporting period, basic EPS and diluted EPS amounts for income from continuing operations, income from discontinued operations, and net income. Entities may voluntarily disclose other per-share metrics in certain circumstances (see further discussion in Section 9.2.3).
2.2 Common Stock and Potential Common Stock
ASC 260-10-20 defines common stock as “stock that is subordinate to all other
stock of the issuer.” Further, potential common stock is defined 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.” Because the valuation of
securities that are considered potential common stock is largely derived from the
value of the related common stock, changes in the value of those securities tend to
reflect changes in the value of the common stock. Examples of financial instruments
that involve potential common stock include share-based payment arrangements,
warrants, and securities convertible into common stock. Preferred stock would not
meet the definition of potential common stock unless it is convertible into common
stock.
2.3 Trading (or Filing in Anticipation of Trading) in a Public Market
Entities whose common stock or potential common stock is not traded in a public
market are not required to apply ASC 260 unless they have filed, or are in the
process of filing, with a regulatory agency in preparation for the sale of common
stock or potential common stock in a public market. Thus, an entity is not required
to present EPS under ASC 260 when (1) its only securities that trade in a public
market are nonconvertible debt securities1 and (2) it has not undertaken any filing in preparation for the sale of common
stock or potential common stock in a public market. However, the entity could
voluntarily present EPS data if it complies with all of the requirements of ASC 260.
The concept of “trades in a public market” under ASC 260 is relatively broad.
ASC 260 specifically mentions that a public market may represent either a recognized
stock exchange (i.e., the New York Stock Exchange [NYSE], the Nasdaq markets, or the
American Stock Exchange [AMEX] in the United States) or an over-the-counter (OTC)
market (also referred to as trading on the “pink sheets” in the United States),
which may include securities quoted only locally or regionally.
It may be intuitive to think that the requirements of ASC 260 apply
to public entities but not nonpublic entities. However, the ASC master glossary
contains various definitions, including four definitions of public entity, two
definitions of publicly traded company, a definition of publicly traded entity, and
a definition of public business entity. While entities subject to the requirements
of ASC 260 will often meet some or all of these definitions, the ASC 260 glossary
does not link any of these definitions to the scope requirements. Therefore, it is
important for an entity to apply the specific guidance in ASC 260-10-15 in
determining whether it is subject to the requirements to present EPS.
In addition to applying to entities whose common stock or potential common stock trades in a public market, ASC 260 applies to any financial statements that will be included in any filing with a regulatory agency in preparation for the sale of those securities in a public market. Most commonly, in the United States, entities file a registration statement under the Securities Act of 1933 (the “Securities Act”) for the initial sale of common stock or potential common stock (e.g., an IPO). Once an entity has registered such securities, it becomes subject to the periodic reporting requirements of the Securities Exchange Act of 1934 (the “Exchange Act”). In such cases, EPS amounts must be presented in the filings under both the Securities Act and Exchange Act if the common stock or potential common stock trades (or, before registration, is intended to trade) in a public market.
2.3.1 Form 10 Registration Statements
Form 10 is a general form that is used to register a class of securities under
Section 12(b) or 12(g) of the Exchange Act. Form 10 is not used to register
securities for sale or resale under the Securities Act. For example, paragraph 1310.2 of the
SEC's Division of Corporation Finance Financial Reporting Manual (FRM) indicates
that, under Section 12(g) of the Exchange Act, any domestic issuer that is not a
bank, bank holding company, or savings and loan holding company must file a Form
10 registration statement with the SEC if its total assets exceed $10 million
and the securities are held by either “(1) 2,000 or more record holders or (2)
500 or more record holders who are not accredited investors.” An issuer that is
a bank, bank holding company, or savings and loan holding company is required to
register a class of equity securities if it has more than $10 million of total
assets and the securities are held by 2,000 persons or more. Form 10
registration statements are also commonly filed in conjunction with certain
spin-off transactions. In addition, any company, regardless of whether it is
publicly held, may voluntarily file a Form 10 registration statement at any
time.2
When a Form 10 registration statement becomes effective, a company becomes subject to the periodic reporting requirements of the Exchange Act, including the requirements to file annual reports on Form 10-K and quarterly reports on Form 10-Q, among other SEC reporting requirements. However, in a manner similar to the filing of a registration statement with the SEC under the Securities Act, the company must meet other requirements for its common stock to trade in the United States on an OTC market or a recognized stock exchange (i.e., NYSE, Nasdaq markets, or AMEX).
Basic and diluted EPS must be presented in a Form 10 registration statement when
the common stock to be registered in the filing will trade in a public market
(i.e., an OTC market or a recognized stock exchange). The only exception would
be the filing of a Form 10 to complete a spin-off of the business operations of
a larger entity that represents a carve-out from the parent. As discussed in
Section 8.6.3.3, carve-out entities’
audited financial statements that are included in Form 10 registration
statements typically do not include EPS, although pro forma EPS is typically
presented outside the audited financial statements. Once the Form 10
registration statement is effective, EPS presentation is required in subsequent
filings on Form 10-K and Form 10-Q.
Connecting the Dots
The requirement in ASC 260-10-15-2 for an entity to present EPS when it files with a regulatory agency in preparation for the sale of common stock or potential common stock in a public market is relatively broad. The requirement would include filings related to either (1) the offering of existing securities or (2) securities that are restricted for resale. Thus, even in such circumstances, EPS presentation is required in a Form 10 registration statement associated with common stock or potential common stock that will trade in a public market.
2.3.2 Termination of Registration of Common Stock
Entities may wish to terminate the registration of their common securities under
Section 12(g) of the Exchange Act. However, even if the SEC reporting
requirements under the Exchange Act are no longer applicable, an entity may
still be required to present EPS because the requirements in ASC 260-10-15-2 for
presentation of EPS do not include a requirement that the entity be registered
with the SEC. Thus, the termination of registration of common stock with the SEC
would not in itself cause an entity to no longer be required to present EPS. For
example, entities with common stock or potential common stock that trade on an
OTC market must present EPS even if those securities are not registered under
the Exchange Act. An entity should consult with its legal advisers regarding the
termination of registration of securities with the SEC.
Footnotes
1
An entity whose only securities that trade in a public
market are debt securities that are convertible into common stock (i.e.,
convertible debt) is required to present EPS data under ASC 260.
2
This background discussion is only included to provide
context for the discussion that follows. Section 12(b) of the Exchange
Act also contains registration and reporting requirements. Entities
should consult with their legal advisers regarding the requirements of
U.S. securities laws.
Chapter 3 — Basic EPS
Chapter 3 — Basic EPS
3.1 Background
ASC 260-10
Basic EPS
10-1 The objective of basic
earnings per share (EPS) is to measure the performance of an
entity over the reporting period.
Computation of Basic EPS
45-10 Basic EPS shall be
computed by dividing income available to common stockholders
(the numerator) by the weighted-average number of common
shares outstanding (the denominator) during the period.
Shares issued during the period and shares reacquired during
the period shall be weighted for the portion of the period
that they were outstanding. See Example 1 (paragraph
260-10-55-38) for an illustration of this guidance.
As noted in ASC 260-10-45-10, basic EPS is calculated “by dividing income
available to common stockholders (the numerator) by the
weighted-average number of common shares outstanding (the
denominator) during the [reporting] period.” For illustrations of
the calculation of basic EPS for entities with simple and more
complex capital structures, see the example below and Example
3-32, respectively. The remainder of this chapter
addresses matters that affect the numerator and denominator in the
calculation of basic EPS.
Example 3-1
Basic EPS for Entity With Simple Capital Structure
This example illustrates the first-quarter calculation of basic EPS for Company A, which has a simple capital structure. Assume the following facts:
- Income from continuing operations and net income for the first quarter was $10 million.
- At the beginning of the period, A had 500,000 shares of common stock outstanding.
- On March 1, A issued 100,000 shares of common stock in a secondary offering.
- Company A only has shares of common stock outstanding. There is no noncontrolling interest (NCI) in A.
Weighted-average shares outstanding are calculated as follows:
The discussion in this chapter is generally in the context of an entity that
presents only one basic EPS amount (i.e., the entity does not have
any discontinued operations). Unless otherwise noted, in this
chapter, “net income” encompasses net income or net loss and refers
to (1) consolidated net income for an entity that does not have an
NCI and (2) income attributable to the parent for an entity with an
NCI. “Income available to common stockholders,” which is defined in
ASC 260-10-20, refers to income available or loss attributable to
common stockholders for (1) an entity that does not have an NCI and
(2) the parent for an entity that has an NCI. Sections
8.6.3, 8.7.1, and 8.7.2
discuss the accounting and presentation of EPS for an entity that
presents a discontinued operation and include an example of the
presentation of EPS for an entity that reports an NCI in a
discontinued operation.
3.1.1 Treating Capital Stock as Common Stock or Preferred Stock
3.1.1.1 Corporate Entities
ASC 260-10-20 defines common stock as “stock that is subordinate to all other stock of the issuer.” ASC 260 does not provide any other interpretive guidance on identifying whether a class of capital stock should be treated as common or preferred stock. However, the distinction is important for both the determination of the classes of capital stock for which the presentation of EPS is required and the calculation of basic and diluted EPS for those classes of capital stock. With respect to the presentation of EPS, as noted in Section 5.4.1, an entity with multiple classes of common stock is required to present basic and diluted EPS for each of these classes. Regarding the calculation of EPS, as discussed in this chapter, there are significant differences between the accounting for common stock and the accounting for preferred stock. Such differences may include the following:
- Dividends on preferred stock affect the numerator in the calculation of EPS, whereas dividends on common stock generally have no impact on EPS unless the two-class method of calculating EPS is required.
- While the classification and measurement guidance in ASC 480-10-S99-3A applies to all equity-classified redeemable securities, the EPS impact of adjustments to the redemption amount of redeemable securities for preferred stock significantly differs from that for common stock.
- According to ASC 260-10-S99-2, the difference between the fair value of consideration paid and the net carrying amount of preferred stock is treated as a dividend when preferred stock is redeemed; ASC 260-10-S99-2 does not apply to common stock.
Securities issued by corporations will typically be considered common stock or
preferred stock on the basis of their existing legal
form. However, in the calculation of basic EPS,
securities should be evaluated on the basis of their
substance rather than just their current legal form.
A security that is a preferred instrument in legal
form, shares the same characteristics as common
stock, and has no substantive preference attributed
to it should be considered a class of common stock
in the calculation of EPS, regardless of its legal
form. Similarly, a security that is a common
instrument in legal form and shares the same
characteristics as preferred stock because of a
substantive preference in dividends and liquidation
(without any participation with common shareholders
in the distribution of assets on liquidation) should
be considered a class of preferred stock in the
calculation of EPS, regardless of its legal form.
The laws in certain jurisdictions do not allow
certain types of entities to issue preference
shares; however, those entities may issue common
securities in legal form that have all the
characteristics of preferred stock. The two examples
below illustrate these concepts.
Example 3-2
Preferred Stock With Characteristics of Common Stock
Company B issues, to Company C, Series A convertible preferred stock (the
“Series A stock”) whose terms are substantially
the same as those of common stock. The relevant
terms of the Series A stock are as follows:
-
No rights to preferential or cumulative dividends; holders of the Series A stock share ratably with common stockholders in the payment of any dividends.
-
Not publicly traded. (B’s common stock is publicly traded.)
-
Voting rights are consistent with the rights of the common stock.
-
Nominal preference in liquidation of $0.01 per share.
-
Each share is convertible into one share of common stock at any time upon the transfer of the Series A stock by C to a third party.
-
Antidilution provisions are limited to stock splits and dividends.
There is no substantive difference between the Series A stock and the common
stock. As a holder of the Series A stock, C can
sell these shares to a third party at any time, at
which point the Series A stock would convert into
common stock with all the characteristics of the
current outstanding common stock. The sale of the
Series A stock is completely outside B’s control,
and there are no restrictions on the sale of the
Series A stock. Further, the Series A stock has
the exact same rights to receive dividends as
common stock and has no substantive preference
(i.e., the liquidation preference of $0.01 per
share is not substantive). Therefore, the Series A
stock should be treated as a class of common
stock.
Example 3-3
Common Stock With Characteristics of Preferred Stock
Company X is a limited liability company (LLC) domiciled and organized under the
laws of The People’s Republic of China (PRC).
According to PRC law, an LLC cannot issue
preference shares. Therefore, X has issued two
classes of shares — ordinary shares and Series A
shares, which is a special class of ordinary
shares. The Series A shares contain preferential
rights that are akin to preferred stock but are
not legally preferred securities because
preference shares cannot be issued by an LLC under
PRC law. The Series A shares result in the
economic equivalent of a preferred security. For
such a security, there is a priority related to
dividend rights and distributions on liquidation
and no ability to participate with ordinary
shareholders in the distribution of assets on
liquidation.
Although the Series A shares, like the ordinary shares, legally reflect common stock, the Series A shares should be considered preferred stock and the ordinary shares should be considered common stock under ASC 260. This is consistent with the definition of common stock in ASC 260-10-20, which refers to “stock that is subordinate to all other stock of the issuer.”
Section 3.3.2.2 discusses the treatment of instruments that are mandatorily convertible into common stock but that do not reflect common stock in substance before their conversion.
3.1.1.2 Limited Partnerships and Similar Entities
In a typical limited partnership, the general partner or partners own an
insignificant amount of partnership interests and
there is a single class of limited partnership
interests that represents substantially all of the
equity of the limited partnership. In these
situations, the limited partnership interests will
be treated as common stock. In other situations, the
general partnership interest or interests represent
a majority of the equity of the limited partnership
or the limited partnership has issued multiple
classes of limited partnership interests. In these
circumstances, the determination of whether the
limited partnership interests should be considered
akin to common stock or preferred stock should be
based on the substance of the instruments. We
understand that the SEC staff believes that if an
issued and outstanding equity interest is not in the
legal form of common stock or preferred stock, which
may include limited partnerships and similar
entities as well as other forms of organization in
foreign jurisdictions, the entity should evaluate
the economic characteristics and risks of the equity
interest, within the context of the entity’s other
capital instruments, to determine whether the
interest is more akin to common stock or preferred
stock. The primary focus should be on whether the
interest has a priority in dividends and a
substantive preference in liquidation.
3.2 Income Available to Common Stockholders
3.2.1 General
ASC 260-10
Income Available to Common Stockholders and Preferred
Dividends
45-11 Income available to common stockholders shall
be computed by deducting both the dividends declared in the period on
preferred stock (whether or not paid) and the dividends accumulated for the
period on cumulative preferred stock (whether or not earned) from income from
continuing operations (if that amount appears in the income statement) and
also from net income. If there is a loss from continuing operations or a net
loss, the amount of the loss shall be increased by those preferred dividends.
An adjustment to net income or loss for preferred stock dividends is required
for all preferred stock dividends, regardless of the form of payment.
Preferred dividends that are cumulative only if earned shall be deducted only
to the extent that they are earned.
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.
45-12 Preferred stock dividends that an issuer has
paid or intends to pay in its own common shares shall be deducted from net
income (or added to the amount of a net loss) in computing income available to
common stockholders. In certain cases, the dividends may be payable in common
shares or cash at the issuer’s option. The adjustment to net income (or net
loss) for preferred stock dividends payable in common stock in computing
income available to common stockholders is consistent with the treatment of
common stock issued for goods or services.
ASC 260-10-45-11 through 45-12 contain general guidance on calculating
the numerator for basic EPS. Generally speaking, income available to common stockholders
is calculated as net income less dividends on preferred stock. However, there are a number
of matters for an entity to consider in performing this calculation. Below is a summary of
the relevant considerations related to the calculation of the numerator for basic EPS
along with references to the sections in this chapter where these matters are discussed.
Chapter 6 contains
additional guidance on calculating basic EPS for convertible debt instruments. See
Section 9.1.6 for
discussion of the requirement for an SEC registrant to report income or loss applicable to
common stock on the face of the income statement.
The table below discusses the impact that various items generally
have on the calculation of income available to common stockholders in the calculation of
basic EPS. Because the table focuses on income available to common stockholders, it does
not address the allocation of such income to multiple classes of common stock, in which
case an entity is required to apply the two-class method of calculating basic EPS. Each of
the items in the table below is discussed in detail in the sections that follow.
Table 3-1
Generally Affects
Income Available to Common Stockholders1 | Generally Does Not
Affect Income Available to Common Stockholders |
---|---|
|
|
3.2.2 Dividends on Preferred Stock
3.2.2.1 General
Dividends on preferred stock are deducted from income from continuing
operations (if that amount appears on the income statement), as well as from net income,
to arrive at income available to common stockholders, which is the numerator in the
calculation of basic EPS. Only dividends associated with the current financial reporting
period are deducted from income from continuing operations (if that amount appears on
the income statement), as well as from net income, to arrive at income available to
common stockholders for the period. For example, as discussed in ASC 260-10-45-60B(a),
if dividends on cumulative preferred stock are declared in the current period but are
related to prior-period unpaid cumulative dividends, those dividends are not associated
with the current financial reporting period. Only dividends that accumulated during the
current period affect income available to common stockholders.
As noted in Section 8.7,
if an entity reports a discontinued operation, it must calculate basic EPS for both
income from continuing operations and net income (thus, income available to common
stockholders should be calculated for both income from continuing operations and net
income). While an entity may have any combination of one or more of income from
continuing operations, loss from continuing operations, net income, or net loss, the
remaining discussion in this chapter generally refers simply to a requirement to deduct
dividends from “net income” to arrive at “income available to common stockholders.” This
reference is intended to encompass (1) the addition of dividends to net loss to arrive
at loss attributable to common stockholders when an entity reports a net loss, (2) the
deduction of dividends from income from continuing operations when an entity reports
income and has a discontinued operation, and (3) the addition of dividends to loss from
continuing operations when an entity reports a loss and has a discontinued operation.
As discussed in the remaining subsections of Section 3.2.2, dividends that
reduce net income in arriving at income available to common stockholders include all of
the following:
- Dividends accumulated on cumulative preferred stock that are paid in cash.
- Dividends declared on noncumulative preferred stock that are paid in cash.
- Dividends accumulated on cumulative preferred stock that are paid in additional shares of preferred stock or in common stock.
- Dividends declared on noncumulative preferred stock that are paid in additional shares of preferred stock or in common stock.
- Contingent dividends on cumulative and noncumulative preferred stock when the contingency that requires the payment of those dividends occurs.
- Liquidating dividends upon the occurrence of the liquidation event.
- The accretion of dividends on certain increasing-rate preferred stock instruments.
- “Deemed dividends” that result from the remeasurement of preferred stock to its redemption amount under ASC 480-10-S99-3A.
-
Dividends that result from a down-round feature that has been triggered.
- “Deemed dividends” that result from the application of ASC 260-10-S99-2 to a redemption or induced conversion of preferred stock.
- Dividends on participating preferred stock.
- “Deemed dividends” from the reclassification of preferred stock to a liability.
3.2.2.2 Cumulative Versus Noncumulative Preferred Stock
3.2.2.2.1 Dividends on Cumulative Preferred Stock
Although the ASC master glossary does not define “cumulative
preferred stock,” preferred stock that must receive dividend payments for all prior
years before any dividend payments are made to common shareholders are described as
cumulative; those without this right are noncumulative. Thus, for cumulative preferred
stock, the dividends accumulate on the basis of the dividend payment terms and
all accumulated dividends must be paid before any dividends may be paid on
common stock.
ASC 260-10-45-11 requires an entity to deduct from net income the
amount of dividends accumulated during a period on cumulative preferred stock. This is
required regardless of whether (1) the form of payment is cash or stock or (2) the
dividends have been declared or paid. However, preferred dividends that are cumulative
only if earned are treated as contingent dividends (see Connecting the Dots below).
Section 3.2.2.3
addresses dividends on increasing-rate preferred stock. Section 3.2.2.4 addresses dividends on redeemable
preferred stock. Section
3.2.2.7 addresses the EPS accounting for cumulative preferred stock that
meets the definition of a participating security.
While cumulative dividends on preferred stock are deducted from the
numerator in the calculation of basic EPS, such dividends are not necessarily
recognized on the balance sheet. For example, if an entity has issued redeemable
preferred stock that is classified in temporary equity, but remeasurement of the
preferred stock to its redemption amount is not required under ASC 480-10-S99-3A,
cumulative undeclared dividends on the preferred stock will have been reflected in the
calculation of basic EPS; however, those dividends would not be reflected in the
measurement of the temporary-equity classified preferred stock under ASC
480-10-S99-3A. The fact that remeasurement of redeemable preferred stock is not
required under ASC 480-10-S99-3A does not negate the requirement in ASC 260 to deduct
cumulative dividends on the preferred stock in the calculation of basic EPS.
Connecting the Dots
The language in ASC 260-10-45-11 that refers to whether
dividends on cumulative preferred stock are “earned” can be confusing. The first
sentence in ASC 260-10-45-11 requires an entity to deduct dividends that
accumulate on cumulative preferred stock for the period “whether or not earned”;
however, the last sentence of that paragraph states that preferred dividends are
cumulative only “if earned” and therefore should be deducted “only to the extent
that they are earned.” The discussion in ASC 260-10-45-11 regarding whether
dividends on cumulative preferred stock are “earned” should be interpreted as
signifying that such dividends for the period should be deducted from net income
to arrive at income available to common stockholders unless the dividends are
contingent upon the occurrence of an event outside the control of the preferred
stockholders that did not occur (e.g., dividends that are indexed to the entity’s
earnings). For further discussion, see Section 3.2.2.2.5.
3.2.2.2.2 Dividends on Noncumulative Preferred Stock
Noncumulative dividends do not accrue to the preferred stockholder
if they are not declared for the period. However, the preferred stockholders are
entitled to receive payment of the current period’s dividend before any dividends can
be declared on common stock. As explained in the nonauthoritative guidance of AICPA
Technical Q&As Section 4210.04, if preferred stock dividends are noncumulative,
“only the dividends declared should be deducted [from net income].” Therefore,
dividends on a noncumulative preferred stock instrument that is not remeasured to its
redemption amount under ASC 480-10-S99-3A and that does not meet the definition of a
participating security should not affect the calculation of basic or diluted EPS for
periods in which such dividends have not been declared or otherwise paid. Section 3.2.2.4 addresses
dividends on redeemable preferred stock. Section 3.2.2.7 addresses the EPS accounting for
noncumulative preferred stock that meets the definition of a participating security.
3.2.2.2.3 Dividends Paid in Shares of Preferred Stock
Dividends on preferred stock may be paid in additional shares of
preferred stock; such dividends are referred to as dividends that are “paid in-kind”
(PIK). Determining the appropriate measurement of PIK dividends is important because
the measured amount of these dividends reduces net income in arriving at income
available to common stockholders.
PIK dividends on preferred stock should be measured at fair value as of the
commitment date for the payment of such dividends. If PIK dividends are
nondiscretionary (i.e., neither the issuer nor the holder may elect to pay dividends
in cash or in kind), the commitment date for the original preferred stock instrument
is also the commitment date for the PIK dividends. If, however, the issuer or the
holder can elect to have dividends paid in cash or in kind, those dividends are
discretionary. Therefore, the commitment date for such dividends is the date on which
they become nondiscretionary (i.e., the date on which the dividends become payable in
kind).
The table below summarizes the measurement guidance related to PIK dividends. See
Section 9.5.5.1 of Deloitte’s Roadmap
Distinguishing Liabilities From Equity
for additional considerations related to determining whether PIK dividends are
discretionary or nondiscretionary.
Table
3-2
Measurement of PIK Dividends That Reduces Numerator in EPS
Calculation | |
---|---|
Commitment date is the same as the commitment date for the original preferred
stock (i.e., nondiscretionary PIK dividends) | PIK dividends should be measured at the fair value of the original preferred
stock on its commitment date. Generally, this will be on the issuance date
of the original preferred stock. |
Commitment date is not the same as the commitment date for the original
preferred stock (i.e., discretionary PIK dividends) | For cumulative
preferred stock, PIK dividends should be measured at their fair value as
of the date they accumulate. If the accumulation date differs from the
declaration or payment date and the entity does not recognize the
dividends on the balance sheet as additional shares of preferred stock
until that later date, an adjustment to the dividend amount previously
recorded should be recognized as of the date the additional shares of
preferred stock are recognized on the balance sheet.2 This adjustment will affect income available to common stockholders
in the period in which it is recognized. For
noncumulative preferred stock, PIK dividends should be measured at their
fair value as of the date they are declared. |
3.2.2.2.4 Dividends Paid in Shares of Common Stock
ASC
260-10
Income Available to Common Stockholders and Preferred
Dividends
45-12 Preferred stock dividends that an issuer
has paid or intends to pay in its own common shares shall be deducted from
net income (or added to the amount of a net loss) in computing income
available to common stockholders. In certain cases, the dividends may be
payable in common shares or cash at the issuer’s option. The adjustment to
net income (or net loss) for preferred stock dividends payable in common
stock in computing income available to common stockholders is consistent
with the treatment of common stock issued for goods or
services.
In accordance with ASC 260-10-45-12, when an entity has paid or
intends to pay dividends on preferred stock in shares of common stock, the adjustment
to the numerator in the calculation of basic EPS should be “consistent with the
treatment of common stock issued for goods or services.” ASC 260-10-45-45 does not
apply to the calculation of basic EPS when an entity has the option of paying
dividends in cash or common stock because ASC 260-10-45-45 only applies to the
calculation of diluted EPS. In accordance with ASC 260-10-45-12, the accounting for
basic EPS depends on whether an entity “has paid or intends to pay” dividends on
preferred stock in common stock.
For dividends on cumulative preferred stock, the amount of dividends
that reduces net income in arriving at income available to common stockholders should
be measured at the fair value of the shares of common stock expected to be delivered
in satisfaction of those dividends. For dividends on noncumulative preferred stock,
the amount of dividends that reduces net income in arriving at income available to
common stockholders should be measured at the fair value of the shares of common stock
that the entity has agreed to pay as a dividend as of the dividend declaration date.
The two examples below illustrate the application of these requirements to cumulative
preferred stock.
Example
3-4
Monetary Value of Dividends Is the Same, Whether Paid
in Cash or Shares of Common Stock
On January 1, 20X1, Entity A issues $10 million of
cumulative preferred stock. The terms of the preferred stock stipulate
that dividends accumulate quarterly, regardless of whether they are
declared, at a per annum rate of 10 percent. Entity A has the option of
paying dividends in either cash or a number of shares of common stock
equal to the cash amount. If A elects payment in shares of common stock,
the number of such shares is determined as of the date the dividends are
paid.
Because the monetary amount of the dividends is the same regardless of the form
of consideration, A should recognize, as a reduction of the numerator in
the calculation of EPS, a dividend on preferred stock of $250,000 in each
quarterly financial reporting period ($10,000,000 × 10% × 1/4 = $250,000).
Example
3-5
Monetary Value of Dividends Is Not the Same, Whether
Paid in Cash or Shares of Common Stock
On January 1, 20X1, Entity B issues $10 million of
cumulative preferred stock. The terms of the preferred stock stipulate
that dividends accumulate quarterly, regardless of whether they are
declared, at a per annum rate of 10 percent. Entity B has the option of
paying dividends in either cash or common stock. If B elects to pay
dividends in common stock, it must deliver a number of shares of common
stock that is equal to the cash amount of the dividends as of the date the
preferred stock was issued. The fair value of B’s common stock as of the
date the preferred stock was issued was $10 per share. Thus, in any period
for which dividends are declared and paid in common stock, B must deliver
to the holder 25,000 shares of common stock. Assume that the option of
paying dividends is not an embedded derivative that must be accounted for
separately under ASC 815-15.
Further assume the
following:
- During the first two years in which the preferred stock was outstanding, B had the intent to and did pay the dividends in cash on a quarterly basis.
- Beginning on January 1, 20X3, B needs to conserve cash for other business reasons and has decided to declare and pay the dividends on the preferred stock in shares of common stock during the year ended December 31, 20X3. The dividends accumulate and are declared on March 15, June 15, September 15, and December 15 of each year. The dividends are then paid within 30 days after declaration.
- On March 15, 20X3, the price of B’s common shares was $11 per share.
- On April 15, 20X3, when the dividends were paid, the price of B’s common shares was $12 per share.
- Entity B has a calendar year-end.
In calculating basic EPS for the first quarter ended March 31, 20X3, B should
recognize a reduction from net income of $275,000 to arrive at income
available to common stockholders (25,000 shares × $11.00 per share). Since
the obligation to deliver 25,000 shares of common stock is considered to
have occurred on March 15, 20X3, B would not subsequently adjust the
dividend amount to reflect the incremental $1.00 per share increase in the
fair value of its common stock.
3.2.2.2.5 Contingent Dividends
While ASC 260-10-45-11 states that dividends should be deducted from
net income to arrive at income available to common stockholders, which is the
numerator in the calculation of basic EPS, it does not specifically address how to
account for dividend payments that are contingent on future events. The only guidance
in ASC 260-10-45-11 that is relevant to this matter is that “[p]referred dividends
that are cumulative only if earned shall be deducted only to the extent that they are
earned.”
In such circumstances, an entity must consider the facts and
circumstances associated with each contingently payable dividend. Generally, the
impact of contingently payable dividends on the calculation of basic EPS depends on
the nature of the contingency. See further discussion in the table below.
Table
3-3
Nature of
Contingency3 | Type of Preferred
Stock | Treatment
|
---|---|---|
Dividends are payable solely after the passage of time provided that the
contingent event does not occur | Cumulative
| Dividends should be
reflected — as they accumulate and without regard to the contingency — as
a reduction of net income in arriving at income available to common
stockholders. If the contingent event occurs and the amount of the
dividends changes as a result (i.e., an increase or decrease in, or an
elimination of, the dividend amount), an entity may recognize an
adjustment to the numerator in the calculation of basic EPS in the period
in which the contingent event occurred. Prior reported EPS amounts should
not be revised. |
Noncumulative | Dividends should be
reflected, when declared, as a reduction of net income in arriving at
income available to common stockholders. A contingency of this type that
could affect the amount of the dividends after they are declared should
not affect the amount of dividends that are reduced from net income to
arrive at income available to common stockholders before the occurrence of
the contingency. If the contingent event occurs and the amount of
dividends changes as a result (i.e., an increase or decrease in, or an
elimination of, the dividend amount), an entity may recognize an
adjustment to the numerator in the calculation of basic EPS in the period
in which the contingent event occurred. Prior reported EPS amounts should
not be revised. | |
Dividends become payable only if the contingent event does
occur | Cumulative
| Dividends that
become payable only upon the occurrence of a contingent event (i.e., that
will not be payable upon the mere passage of time provided that no changes
in circumstances or events occur) should not affect the numerator in the
calculation of EPS until and unless the contingency occurs. |
Noncumulative |
Dividends that become payable only upon the occurrence
of a contingent event (i.e., that will not be payable upon the mere
passage of time with no changes in circumstances or events) should not
affect the numerator in the calculation of EPS until the contingency
occurs and the dividend has been declared. |
The example below illustrates the accounting for contingent
dividends.
Example
3-6
Contingent Dividends on Cumulative Convertible Preferred Stock
Company X issued, to Company Y, convertible preferred stock that earns a 7
percent annual dividend on a cumulative basis. The terms of the preferred
stock state that if Y were to convert the preferred stock into common
stock, Y would not receive any preferred stock dividends, including any in
arrears. Conversion is based on the initial issuance price of $1,000 per
share of preferred stock divided by the 30-day average market price of X’s
common stock. If, however, X redeems the shares from Y, Y would receive
dividends, including any in arrears.
The dividends potentially will be paid in the future unless Y elects to convert
the preferred stock into common stock, in which case it would no longer
have the right to receive the preferred stock dividends, including any in
arrears. Therefore, in the calculation of basic EPS, cumulative dividends
on the preferred stock should be subtracted from net income in arriving at
income available to common stockholders until the conversion occurs. If
conversion occurs, thereby removing Y’s right to receive the dividends,
including those in arrears, the calculation of basic EPS may reflect the
reversal of previously accumulated dividends in the quarter in which
conversion occurs. Company X should not revise previously reported EPS
amounts.
3.2.2.2.6 Liquidating Dividends
A liquidating dividend represents a type of distribution made by an
entity to its equity owners during its partial or complete liquidation. Liquidating
dividends are not paid solely out of the entity’s profits. Preferred stock has a
liquidation preference, which represents a right of preference over common
shareholders (and potentially preferences with respect to other classes of preferred
securities) in the event that the issuing entity is liquidated. As with the treatment
of contingent dividends (see Section
3.2.2.2.5), the calculation of income available to common stockholders
should not be affected by a liquidating dividend until a liquidation event occurs.
Similarly, changes to the liquidation preference of preferred stock that have no other
impact on the preferred stock (i.e., the change is only relevant in the event of a
liquidation of the issuing entity and does not affect the dividends on the preferred
stock before such liquidation) should also have no impact on income available to
common stockholders unless such changes result in a “deemed dividend” that must be
accounted for as a result of a modification to the terms of the preferred stock (see
Section 3.2.6.1).4 The example below illustrates the accounting for a liquidating dividend on
cumulative preferred stock.
Example
3-7
Impact of Liquidating Dividends on Cumulative Convertible Preferred
Stock
Assume the following facts:
- Company X issues 100,000 shares of Series A nonvoting convertible preferred stock for $1,000 per share (i.e., total proceeds of $100 million).
- The preferred stock pays cumulative dividends at a rate of 12 percent per annum from the issuance date.
- The liquidation preference of the preferred stock is equal to $1,000 per share, plus dividends accumulated and unpaid at a rate of 12 percent per annum, plus additional dividends at a rate of 5 percent per annum of the issuance price.
- The additional 5 percent that is added to the liquidation preference does not represent a cumulative dividend because it only represents a right of preference in liquidation of X. Company X can pay dividends on common stock provided that it has declared and paid all the cumulative dividends at a rate of 12 percent per annum.
- Company X can call the preferred stock at the end of five years from the issuance date, and on each successive date that is five years thereafter, at a redemption price equal to the issuance price per share, plus unpaid cumulative dividends at the 12 percent rate per annum.
In the calculation of basic EPS, net income
should be reduced by the 12 percent cumulative dividends, regardless of
whether they have been declared or paid. The additional 5 percent per
annum amount that is added to the liquidation preference is not considered
a cumulative dividend even though it accumulates and is added to the total
liquidation preference. Rather, that amount is considered a liquidating
dividend that merely increases the liquidation preference of the preferred
stock. That amount should have no impact on EPS because it is not
reflected for accounting purposes unless there is a liquidation of X.
If the additional 5 percent was also payable upon
a deemed liquidation of X (i.e., a change of control or sale of all or
substantially all of X’s assets), the conclusion would not change because
this dividend amount would still be considered a contingent dividend. See
also Table
3-3.
3.2.2.3 Increasing-Rate Preferred Stock
SEC Staff Accounting Bulletins
SAB Topic 5.Q, Increasing Rate
Preferred Stock [Reproduced in ASC 505-10-S99-7]
Facts: A registrant issues Class A
and Class B nonredeemable preferred stock19 on 1/1/X1. Class A,
by its terms, will pay no dividends during the years 20X1 through 20X3.
Class B, by its terms, will pay dividends at annual rates of $2, $4 and $6
per share in the years 20X1, 20X2 and 20X3, respectively. Beginning in the
year 20X4 and thereafter as long as they remain outstanding, each instrument
will pay dividends at an annual rate of $8 per share. In all periods, the
scheduled dividends are cumulative.
At the time of issuance, eight percent per annum was
considered to be a market rate for dividend yield on Class A, given its
characteristics other than scheduled cash dividend entitlements (voting
rights, liquidation preference, etc.), as well as the registrant’s financial
condition and future economic prospects. Thus, the registrant could have
expected to receive proceeds of approximately $100 per share for Class A if
the dividend rate of $8 per share (the “perpetual dividend”) had been in
effect at date of issuance. In consideration of the dividend payment terms,
however, Class A was issued for proceeds of $79 3/8 per share. The
difference, $20 5/8, approximated the value of the absence of $8 per share
dividends annually for three years, discounted at 8%.
The issuance price of Class B shares was determined by a
similar approach, based on the terms and characteristics of the Class B
shares.
Question 1: How should preferred
stocks of this general type (referred to as “increasing rate preferred
stocks”) be reported in the balance sheet?
Interpretive Response: As is
normally the case with other types of securities, increasing rate preferred
stock should be recorded initially at its fair value on date of issuance.
Thereafter, the carrying amount should be increased periodically as
discussed in the Interpretive Response to Question 2.
Question 2: Is it acceptable to
recognize the dividend costs of increasing rate preferred stocks according
to their stated dividend schedules?
Interpretive Response: No. The
staff believes that when consideration received for preferred stocks
reflects expectations of future dividend streams, as is normally the case
with cumulative preferred stocks, any discount due to an absence of
dividends (as with Class A) or gradually increasing dividends (as with Class
B) for an initial period represents prepaid, unstated dividend
cost.20 Recognizing the dividend cost of these instruments
according to their stated dividend schedules would report Class A as being
cost-free, and would report the cost of Class B at less than its effective
cost, from the standpoint of common stock interests (i.e., for purposes of
computing income applicable to common stock and earnings per common share)
during the years 20X1 through 20X3.
Accordingly, the staff believes that discounts on
increasing rate preferred stock should be amortized over the period(s)
preceding commencement of the perpetual dividend, by charging imputed
dividend cost against retained earnings and increasing the carrying amount
of the preferred stock by a corresponding amount. The discount at time of
issuance should be computed as the present value of the difference between
(a) dividends that will be payable, if any, in the period(s) preceding
commencement of the perpetual dividend; and (b) the perpetual dividend
amount for a corresponding number of periods; discounted at a market rate
for dividend yield on preferred stocks that are comparable (other than with
respect to dividend payment schedules) from an investment standpoint. The
amortization in each period should be the amount which, together with any
stated dividend for the period (ignoring fluctuations in stated dividend
amounts that might result from variable rates,21 results in a
constant rate of effective cost vis-a-vis the carrying amount of the
preferred stock (the market rate that was used to compute the discount).
Simplified (ignoring quarterly calculations) application
of this accounting to the Class A preferred stock described in the “Facts”
section of this bulletin would produce the following results on a per share
basis:
During 20X4 and thereafter, the stated dividend of $8
measured against the carrying amount of $10022 would reflect
dividend cost of 8%, the market rate at time of issuance.
The staff believes that existing authoritative literature,
while not explicitly addressing increasing rate preferred stocks, implicitly
calls for the accounting described in this bulletin.
The pervasive, fundamental principle of accrual accounting
would, in the staff’s view, preclude registrants from recognizing the
dividend cost on the basis of whatever cash payment schedule might be
arranged. Furthermore, recognition of the effective cost of unstated rights
and privileges is well-established in accounting, and is specifically called
for by FASB ASC Subtopic 835-30, Interest — Imputation of Interest, and
Topic 3.C of this codification for unstated interest costs of debt capital
and unstated dividend costs of redeemable preferred stock capital,
respectively. The staff believes that the requirement to recognize the
effective periodic cost of capital applies also to nonredeemable preferred
stocks because, for that purpose, the distinction between debt capital and
preferred equity capital (whether redeemable23 or nonredeemable)
is irrelevant from the standpoint of common stock interests.
Question 3: Would the accounting
for discounts on increasing rate preferred stock be affected by variable
stated dividend rates?
Interpretive Response: No. If
stated dividends on an increasing rate preferred stock are variable,
computations of initial discount and subsequent amortization should be based
on the value of the applicable index at date of issuance and should not be
affected by subsequent changes in the index.
For example, assume that a preferred stock issued 1/1/X1
is scheduled to pay dividends at annual rates, applied to the stock’s par
value, equal to 20% of the actual (fluctuating) market yield on a particular
Treasury security in 20X1 and 20X2, and 90% of the fluctuating market yield
in 20X3 and thereafter. The discount would be computed as the present value
of a two-year dividend stream equal to 70% (90% less 20%) of the 1/1/X1
Treasury security yield, annually, on the stock’s par value. The discount
would be amortized in years 20X1 and 20X2 so that, together with 20% of the
1/1/X1 Treasury yield on the stock’s par value, a constant rate of cost
vis-a-vis the stock’s carrying amount would result. Changes in the Treasury
security yield during 20X1 and 20X2 would, of course, cause the rate of
total reported preferred dividend cost (amortization of discount plus cash
dividends) in those years to be more or less than the rate indicated by
discount amortization plus 20% of the 1/1/X1 Treasury security yield.
However, the fluctuations would be due solely to the impact of changes in
the index on the stated dividends for those periods.
____________________
19 “Nonredeemable” preferred stock, as used in
this SAB, refers to preferred stocks which are not redeemable or are
redeemable only at the option of the issuer.
20 As described in the “Facts” section of this
issue, a registrant would receive less in proceeds for a preferred stock, if
the stock were to pay less than its perpetual dividend for some initial
period(s), than if it were to pay the perpetual dividend from date of
issuance. The staff views the discount on increasing rate preferred stock as
equivalent to a prepayment of dividends by the issuer, as though the issuer
had concurrently (a) issued the stock with the perpetual dividend being
payable from date of issuance, and (b) returned to the investor a portion of
the proceeds representing the present value of certain future dividend
entitlements which the investor agreed to forgo.
21 See Question 3 regarding variable increasing
rate preferred stocks.
22 It should be noted that the $100 per share
amount used in this issue is for illustrative purposes, and is not intended
to imply that application of this issue will necessarily result in the
carrying amount of a nonredeemable preferred stock being accreted to its par
value, stated value, voluntary redemption value or involuntary liquidation
value.
23 Application of the interest method with
respect to redeemable preferred stocks pursuant to Topic 3.C results in
accounting consistent with the provisions of this bulletin irrespective of
whether the redeemable preferred stocks have constant or increasing stated
dividend rates. The interest method, as described in FASB ASC Subtopic
835-30, produces a constant effective periodic rate of cost that is
comprised of amortization of discount as well as the stated cost in each
period.
In accordance with SAB Topic 5.Q, the SEC staff believes that an
entity must use the interest method to recognize dividends on increasing-rate preferred
stock. Although SAB Topic 5.Q specifically discusses preferred stock issued at a
discount to its liquidation preference, with stated dividends that increase over time,
the guidance also applies to preferred stock issued at its liquidation preference that
contains a stated dividend rate that increases over time. Further, the guidance applies
to both redeemable and nonredeemable preferred stock.
The specific terms of preferred stock must be analyzed to determine
whether the instrument is considered increasing-rate preferred stock to which SAB Topic
5.Q must be applied. The table below discusses the application of SAB Topic 5.Q to
certain types of preferred stock instruments, including the interaction between SAB
Topic 5.Q and the SEC’s guidance on redeemable preferred stock in ASC 480-10-S99-3A. The
discussion in the table assumes that no issuance costs are capitalized into the initial
carrying amount of the preferred stock and that any discount on the preferred stock
arises solely from an issuance price that is less than the preferred stock’s stated
liquidation preference. In the table, it is also assumed that callable preferred stock
is called by the issuer before the dividend “step-up.” If the preferred stock is not
called, a reassessment of the accounting may be necessary.
Table 3-4
Type of Preferred
Stock | Example | Application of SAB
Topic 5.Q |
---|---|---|
1.
Noncumulative preferred stock | Entity A
issues noncumulative preferred stock with a $1,000 liquidation preference
and receives $900. The stated dividends on the preferred stock increase over
time. The preferred stock may be callable or puttable. | SAB Topic 5.Q does
not apply to preferred stock with noncumulative dividends even if the
preferred stock was issued at a discount to its liquidation preference or
has a stated rate of dividends that increase over time. Dividends on
noncumulative preferred stock should be recognized as a reduction of net
income to arrive at income available to common stockholders only when
declared. There is no requirement to amortize any discount between the
issuance price and liquidation preference of the preferred stock unless the
preferred stock is a redeemable security subject to the remeasurement
requirements of ASC 480-10-S99-3A. |
2.
Cumulative preferred stock with fixed-rate dividends that do not increase
over time | Entity B
issues cumulative, 8 percent preferred stock with a $1,000 liquidation
preference and receives $900. The preferred stock may be callable or
puttable. | SAB Topic 5.Q does
not apply to preferred stock with cumulative dividends at a stated rate that
do not increase over time even if the preferred stock was issued at a
discount to its liquidation preference. (For this purpose, dividends would
be considered to be at a stated rate that does not increase over time if the
potential to increase is due solely to an increase in a market variable
rate.) Dividends on the cumulative preferred stock should be recognized at
the stated rate as a reduction of net income to arrive at income available
to common stockholders as the dividends accumulate, regardless of whether
they are declared. There is no requirement to amortize any discount between
the issuance price and liquidation preference of the preferred stock unless
the preferred stock is a redeemable security subject to the remeasurement
requirements of ASC 480-10-S99-3A. |
3.
Cumulative preferred stock with fixed-rate dividends that increase over
time | SAB Topic 5.Q applies
to preferred stock with cumulative dividends that increase over time if the
instrument was issued at a discount to its liquidation preference or the
“step-up” in the stated dividends occurs before the date on which the issuer
may call the instrument.(a) | |
3a.
Perpetual preferred stock | Entity C
issues perpetual cumulative preferred stock with a $1,000 liquidation
preference. The dividends on the preferred stock initially accumulate at
5 percent per annum and periodically increase thereafter. The preferred
stock may be issued at its liquidation preference or at a discount to its
liquidation preference.(a) | SAB Topic 5.Q applies to perpetual preferred stock that is issued at its
liquidation preference or at a discount to its liquidation preference if the
stated dividends on the preferred stock increase over time. Dividends on the
cumulative preferred stock should be recognized as a reduction of net income
to arrive at income available to common stockholders as they accumulate,
regardless of whether the dividends are declared, on the basis of the
interest method. If the preferred stock was issued at a discount to the
liquidation preference, that discount should be included with the
increasing-rate dividends in the recognition of dividends under the interest
method.(b) The accretion of any such discount affects the
carrying amount of the preferred stock on the balance sheet (i.e., the
accretion is not just for EPS purposes). |
3b.
Puttable preferred stock | Entity D issues puttable cumulative preferred stock with a $1,000 liquidation
preference. The dividends on the preferred stock initially accumulate at
5 percent per annum and periodically increase thereafter. The preferred
stock may be issued at its liquidation preference or at a discount to its
liquidation preference.(a) The preferred stock may also be
callable by the issuer. | The application of
SAB Topic 5.Q depends on whether the preferred stock was issued at a
discount to the liquidation preference or whether the issuer can call the
preferred stock before the “step-up” in the stated dividend rate. The fact
that the holder may put the instrument does not obviate the need to apply
SAB Topic 5.Q, since the issuer does not control the holder’s decision to
put the instrument; however, the put feature could affect how SAB Topic 5.Q
is applied. Dividends on the cumulative preferred stock should be recognized
as a reduction of net income to arrive at income available to common
stockholders as they accumulate, regardless of whether they are declared, as
follows:
|
3c.
Callable preferred stock | Entity E
issues callable cumulative preferred stock with a $1,000 liquidation
preference. The dividends on the preferred stock initially accumulate at
5 percent per annum and periodically increase thereafter starting at the
beginning of year 5. The issuer can call the preferred stock for its
liquidation preference at the beginning of year 5. The preferred stock may
be issued at its liquidation preference or at a discount to its liquidation
preference.(a) The preferred stock is not puttable by the
holder.(f) | The application of
SAB Topic 5.Q depends on whether the preferred stock was issued at a
discount to the liquidation preference and when the issuer can call the
preferred stock. Dividends on the cumulative preferred stock should be
recognized as a reduction of net income to arrive at income available to
common stockholders as they accumulate, regardless of whether they are
declared, as follows:
|
4.
Cumulative preferred stock with fixed-rate dividends that increase over time
only if a contingent event occurs | Entity F
issues cumulative preferred stock with a $1,000 liquidation preference.
Dividends on the preferred stock accumulate at a rate of 6 percent per
annum. The preferred stock is puttable at the option of the holder upon the
occurrence of a specified contingency that is outside the control of the
investor.(g) If the holder elects to put the preferred stock
upon the occurrence of the specified contingency, F can either redeem the
preferred stock at an amount equal to 130 percent of the liquidation
preference or not redeem the instrument, in which case the dividend rate on
the preferred stock increases to 10 percent per annum. | SAB Topic 5.Q does
not address situations in which the dividend increase results from a
substantive contingency that is outside the control of the investor. In a
manner consistent with the accounting for contingent dividends (see
Section
3.2.2.2.5), if the “step-up” in the dividend rate will not be
operative upon the mere passage of time and the investor does not control
the conditions that would result in an increase in the dividend rate,
dividends should accumulate and reduce net income in arriving at income
available to common stockholders on the basis of the stated rate, provided
that the contingent event that results in an increase in dividends does not
occur. The additional contingent dividends should be deducted from net
income in arriving at income available to common stockholders only when the
contingent event that requires such payment occurs. |
Notes to Table:
(a) Preferred stock is generally considered to have been
issued at a discount to its liquidation preference at any time the issuance
price (i.e., proceeds received from the investor before direct issuance
costs paid to third parties) is less than the preference that the holder of
the preferred stock has in liquidation of the issuing entity. For example,
preferred stock that is issued to an investor for $1 million that is
redeemable for $1 million plus a premium (whether in accordance with a call
option or put option) is considered to have been issued at a discount to its
liquidation preference. As another example, preferred stock is considered to
have been issued at a discount to its liquidation preference when the
preferred stock is issued with other freestanding financial statements
(e.g., detachable warrants) and the allocation of the proceeds to the
preferred stock results in an initial carrying amount that is less than its
liquidation preference. However, the mere fact that preferred stock has been
issued at a discount to its liquidation preference does not mean that SAB
Topic 5.Q applies to the recognition of dividends.
(b) The issuer may need to estimate (or derive) a life to
calculate an effective yield under the interest method.
(c) ASC 480-10-S99-3A may require remeasurement of the
preferred stock to its redemption amount if the redemption amount exceeds
the net carrying amount of the preferred stock before application of ASC
480-10-S99-3A.
(d) If the issuer does not intend to call the preferred
stock on the first dividend “step-up” date (or when the preferred stock is
otherwise first callable) because it is not economically advantageous to
call the preferred stock in considering the discount to the liquidation
preference and the increased dividends, SAB Topic 5.Q may be applied
differently. The application of SAB Topic 5.Q to the discount and the
“step-feature” will depend on the particular facts and circumstances. For
example, an application of the interest method on the basis of the expected
life of the instrument, as discussed in the second approach under footnote
(e), may be appropriate.
(e) When an issuer expects to exercise a call option to
avoid paying any dividends at a higher or “stepped-up” rate (i.e., the call
option may be exercised before the date the dividends increase), it is
generally most appropriate for the issuer to use the interest method to
amortize the entire discount between the issuance price and liquidation
preference over a period that ends with the call date. However, prior
informal discussions with the SEC staff have revealed that other approaches
may also be acceptable, including the following:
(f) If the preferred stock were puttable, the issuer would
also need to consider ASC 480-10-S99-3A.
(g) The increased dividends may result from penalty
payments upon the issuer’s failure to take certain actions (e.g., failure to
deliver common shares upon conversion within a stated period) or declines in
the issuer’s creditworthiness. If the investor controls the occurrence of
the events that result in the requirement for the issuer to either redeem
the preferred stock at a premium or increase the dividends, the preferred
stock would not be considered to have contingent increasing-rate dividends.
Therefore, the issuer would need to accrete the preferred stock instrument
on the basis of the greater of the redemption price or the increased
dividend rate.
|
Connecting the Dots
An issuer cannot avoid applying the SEC’s guidance on increasing-rate preferred
stock on the basis that the holder may convert a preferred stock instrument into the
issuer’s common shares before the stated dividend rate increases. The issuer does
not control the ability to require the instrument to be converted into common stock
and therefore does not have the unilateral ability to avoid an increase in the
dividend rate. The same conclusion applies to a convertible preferred stock
instrument that is mandatorily convertible into the issuer’s common shares if the
issuer’s stock price increases to a stated amount per share.
Although ASC 480-10-S99-3A(15) gives an entity the option of
recognizing redemption-amount measurement adjustments related to redeemable preferred
stock by using one of two methods when preferred stock is not redeemable on the balance
sheet date but it is probable that it will become redeemable (i.e., an accretion method
or a method that assumes the preferred stock is redeemable on the balance sheet date),
the entity must apply the effective yield method when SAB Topic 5.Q applies. Under SAB
Topic 5.Q, it is not appropriate to immediately recognize the entire discount between
the issuance price and the liquidation preference related to increasing-rate preferred
stock. Rather, an entity applies the SEC’s guidance on increasing-rate preferred stock
independently from the guidance on redeemable equity securities. However, some preferred
stock instruments may be subject to both sets of requirements.
3.2.2.4 Redeemable Preferred Stock
SEC Staff Accounting Bulletins
SAB Topic 3.C, Redeemable Preferred
Stock [Reproduced in ASC 480-10-S99-2]
Facts: Rule 5-02.27 of Regulation
S-X states that redeemable preferred stocks are not to be included in
amounts reported as stockholders’ equity, and that their redemption amounts
are to be shown on the face of the balance sheet. However, the Commission’s
rules and regulations do not address the carrying amount at which redeemable
preferred stock should be reported, or how changes in its carrying amount
should be treated in calculations of earnings per share . . . .
Question 1: How should the
carrying amount of redeemable preferred stock be determined?
Interpretive Response: The initial
carrying amount of redeemable preferred stock should be its fair value at
date of issue. Where fair value at date of issue is less than the mandatory
redemption amount, the carrying amount shall be increased by periodic
accretions, using the interest method, so that the carrying amount will
equal the mandatory redemption amount at the mandatory redemption date. The
carrying amount shall be further periodically increased by amounts
representing dividends not currently declared or paid, but which will be
payable under the mandatory redemption features, or for which ultimate
payment is not solely within the control of the registrant (e.g., dividends
that will be payable out of future earnings). Each type of increase in
carrying amount shall be effected by charges against retained earnings or,
in the absence of retained earnings, by charges against paid-in capital.
The accounting described in the preceding paragraph would
apply irrespective of whether the redeemable preferred stock may be
voluntarily redeemed by the issuer prior to the mandatory redemption date,
or whether it may be converted into another class of securities by the
holder. Companies also should consider the guidance in FASB ASC paragraph
480-10-S99-3A (Distinguishing Liabilities from Equity Topic).
Question 2: How should periodic
increases in the carrying amount of redeemable preferred stock be treated in
calculations of earnings per share . . . ?
Interpretive Response: Each type
of increase in carrying amount described in the Interpretive Response to
Question 1 should be treated in the same manner as dividends on
nonredeemable preferred stock.
ASC 480-10 — SEC
Materials — SEC Staff Guidance
SEC Staff
Announcement: Classification and Measurement of Redeemable Securities
S99-3A(20)
Preferred stock instruments issued by a parent (or single reporting
entity). Regardless of the accounting method selected in paragraph 15
and the redemption terms (that is, fixed price or fair value), the resulting
increases or decreases in the carrying amount of a redeemable instrument
other than 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. Increases or decreases in the carrying amount should reduce or
increase income available to common stockholders in the calculation of
earnings per share . . . . Additionally, Paragraph 260-10-S99-2, provides
guidance on the accounting at the date of a redemption or induced conversion
of a preferred stock instrument.
In accordance with ASR 268, as interpreted by SAB Topic 3.C and ASC
480-10-S99-3A, preferred stock that is redeemable at the option of the holder or upon
the occurrence of an event outside the issuer’s control, other than an ordinary
liquidation, must be classified in temporary equity by an SEC registrant. Furthermore,
if the preferred stock is currently redeemable or it is probable that it will become
redeemable, the preferred stock must be periodically remeasured to its redemption
amount. Regardless of whether the redemption price represents a fair value or non–fair
value amount upon redemption, adjustments to remeasure redeemable preferred stock to its
redemption amount represent “deemed dividends” that must be reduced from net income in
arriving at income available to common stockholders.
ASC 480-10-S99-3A(14) states, in part, that when preferred stock “is
currently redeemable (for example, at the option of the holder), it should be adjusted
to its maximum redemption amount at the balance sheet date.” If the preferred stock is
not currently redeemable, but it is probable that it will become redeemable (for
example, when the redemption depends solely on the passage of time), an entity can
select one of two methods to remeasure the preferred stock to its redemption amount. ASC
480-10-S99-3A(15) describes these two methods as follows:
-
Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates.
-
Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.
The method applied under ASC 480-10-S99-3A(15) to remeasure preferred
stock to its redemption amount will affect the periodic amount of “deemed dividends”
that reduce net income in arriving at income available to common stockholders. ASC
480-10-S99-3A(16)(e) stipulates that decreases to the carrying amount that result from
the application of ASC 480-10-S99-3A may only be recognized to the extent that such
decreases reflect recoveries of previously recognized increases to the carrying amount
as a result of the application of ASC 480-10-S99-3A. For additional guidance on applying
the SEC’s guidance on redeemable securities, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.
Connecting the Dots
The redemption amount of redeemable preferred stock may vary
(e.g., it may be the fair value of the preferred stock or it may be based on an
index). In these situations, ASC 480-10-S99-3A allows an entity to reverse prior
increases in the carrying amount of the preferred stock that resulted from the
application of the subsequent-measurement guidance in ASC 480-10-S99-3A. These
increases would reverse the “deemed dividends” recorded in prior periods and would
be treated as a “deemed contribution” by the preferred stockholder. Thus, the
adjustment to net income to arrive at income available to common stockholders in a
particular period could be positive (i.e., a “credit” resulting from the reduction
of the redemption amount of redeemable preferred stock). However, on a cumulative
basis, adjustments to remeasure redeemable preferred stock to its redemption amount
may not be negative (i.e., cumulatively, there cannot be a positive adjustment to
net income in arriving at income available to common stockholders). ASC
480-10-S99-3A(16)(e) states:
[R]egardless of the accounting
method applied [the immediate or accretion method], the amount presented in
temporary equity should be no less than the initial amount reported in temporary
equity for the instrument. That is, reductions in the carrying amount of a
redeemable equity instrument from the application of [the immediate method or
accretion method] are appropriate only to the extent that the registrant has
previously recorded increases in the carrying amount of the redeemable equity
instrument from the application of [the immediate method or accretion method].
See Section
3.2.2.6.2.2 for discussion of the accounting for a redemption of redeemable
preferred stock that has been remeasured under ASC 480-10-S99-3A.
3.2.2.5 Convertible Preferred Stock
3.2.2.5.1 Convertible Preferred Stock That Contains a Down-Round Feature
ASC 260-10
Financial Instruments That Include a
Down Round Feature
25-1 An entity that presents
earnings per share (EPS) in accordance with this Topic shall recognize the
value of the effect of a down round feature in an equity-classified
freestanding financial instrument and an equity-classified convertible
preferred stock (if the conversion feature has not been bifurcated in
accordance with other guidance) when the down round feature is triggered.
That effect shall be treated as a dividend and as a reduction of income
available to common stockholders in basic earnings per share, in
accordance with the guidance in paragraph 260-10-45-12B. See paragraphs
260-10-55-95 through 55-97 for an illustration of this guidance.
Financial Instruments That Include a
Down Round Feature
30-1 As of the date that a
down round feature is triggered (that is, upon the occurrence of the
triggering event that results in a reduction of the strike price) in an
equity-classified freestanding financial instrument and an
equity-classified convertible preferred stock (if the conversion feature
has not been bifurcated in accordance with other guidance), an entity
shall measure the value of the effect of the feature as the difference
between the following amounts determined immediately after the down round
feature is triggered:
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.
30-2 The fair values of the
financial instruments in paragraph 260-10-30-1 shall be measured in
accordance with the guidance in Topic 820 on fair value measurement. See
paragraph 260-10-45-12B for related earnings per share guidance and
paragraphs 505-10-50-3 through 50-3A for related disclosure guidance.
Financial Instruments That Include a Down Round Feature
35-1 An entity shall
recognize the value of the effect of a down round feature in an
equity-classified freestanding financial instrument and an
equity-classified convertible preferred stock (if the conversion feature
has not been bifurcated in accordance with other guidance) each time it is
triggered but shall not otherwise subsequently remeasure the value of a
down round feature that it has recognized and measured in accordance with
paragraphs 260-10-25-1 and 260-10-30-1 through 30-2. An entity shall not
subsequently amortize the amount in additional paid-in capital arising
from recognizing the value of the effect of the down round feature.
Freestanding Equity-Classified
Financial Instrument With a Down Round Feature
45-12B For a freestanding
equity-classified financial instrument and an equity-classified
convertible preferred stock (if the conversion feature has not been
bifurcated in accordance with other guidance) with a down round feature,
an entity shall deduct the value of the effect of a down round feature (as
recognized in accordance with paragraph 260-10-25-1 and measured in
accordance with paragraphs 260-10-30-1 through 30-2) in computing income
available to common stockholders when that feature has been triggered
(that is, upon the occurrence of the triggering event that results in a
reduction of the strike price).
Under ASC 260, when a down-round feature in convertible preferred
stock is triggered (i.e., when the conversion price is adjusted), an entity must
immediately recognize a dividend (which reduces the numerator in the calculation of
basic EPS) on the basis of the increase in the fair value of the instrument. This
accounting is the same as the treatment of a down-round feature in a freestanding
equity-linked financial instrument, such as a warrant (see Section 3.2.5.3). However, down-round features in
convertible debt instruments do not affect EPS (i.e., they are not recognized as
dividends when they are triggered).
3.2.2.5.2 Redeemable Convertible Preferred Stock
The guidance in ASC 480-10-S99-3A on the subsequent measurement of
redeemable equity securities applies to convertible preferred stock that (1) is
currently redeemable or (2) it is probable will become redeemable. See Section 3.2.2.4 for discussion of
the application of ASC 480-10-S99-3A to redeemable preferred stock. See Sections 3.2.5.2.4 and 3.2.5.2.5 for additional guidance
on redeemable convertible preferred stock that contains a separately classified equity
component.
3.2.2.5.3 Participating Convertible Preferred Stock
Section
3.2.2.7 discusses the EPS accounting for participating convertible
preferred stock.
3.2.2.5.4 Accounting for a Conversion of Convertible Preferred Stock
A settlement of convertible preferred stock through the issuance of
common shares in accordance with the stated conversion privileges in the convertible
preferred stock agreement is not subject to ASC 260-10-S99-2 and has no incremental
impact on income available to common stockholders in the calculation of basic EPS,
provided that (1) the settlement is considered a “conversion” and (2) no component of
the convertible preferred stock instrument is separately classified either as a
derivative liability or within stockholders’ equity. Section 3.2.2.6.2.1 discusses whether a settlement
of convertible preferred stock is treated as a “conversion” or a redemption. Section 3.2.2.5.4.1 discusses the
EPS accounting for a settlement of a preferred stock host contract and an embedded
conversion option liability when the settlement is considered a “conversion.”
Section 3.2.2.5.4.2
discusses the EPS accounting for a settlement of convertible preferred stock that
contains a separately recognized equity component when the settlement is considered a
“conversion.” Section
3.2.2.6.3 discusses the EPS accounting for a settlement of convertible
preferred stock that arises from an induced conversion.
3.2.2.5.4.1 Convertible Preferred Stock That Contains an Embedded Conversion Option Accounted for as a Derivative Liability
The Codification does not specifically address the accounting for
a settlement of a preferred stock host contract and a separated embedded conversion
option liability through the issuance of common stock under the original conversion
terms of the instrument. As a result, there may be alternative views on the
accounting upon a settlement. The acceptable alternative views, when the settlement
is considered a conversion according to the original conversion privileges, as
opposed to a redemption or an induced conversion, are as follows:5
-
Redemption accounting — Even though the settlement occurred in accordance with the contractual conversion terms, it is treated as a redemption since the embedded conversion option was separated as a liability. As a result, an adjustment is made to net income in arriving at income available to common stockholders in accordance with ASC 260-10-S99-2. That adjustment, which is recognized in retained earnings, will equal the difference between the settlement-date fair value of the common stock issued on conversion and the aggregate of the carrying amounts of the preferred stock host contract and the separated embedded conversion option liability, as adjusted immediately before redemption accounting is applied.When entities use this approach, there is diversity in practice related to the adjustment to the carrying amount of the separated liability for the embedded conversion option that is made immediately before redemption accounting is applied. Some entities will adjust the liability for the embedded conversion option to its fair value under ASC 820 immediately before applying redemption accounting. Other entities will adjust the liability for the embedded conversion option to the fair value of the common stock issued upon conversion, or its “intrinsic value,” immediately before applying redemption accounting. While the final adjustment to the embedded conversion option liability may result in a gain or loss that is recognized in earnings under either approach, entities that apply the latter approach will recognize a larger gain or a smaller loss in earnings as a result of the reversal of any remaining time value in the embedded conversion option liability. Even if the latter view is applied to the adjustment of the carrying amount of the embedded conversion option liability, an adjustment will still be required under ASC 260-10-S99-2 if there is any unamortized discount or premium on the convertible preferred stock host contract. The accounting becomes more complex if the convertible preferred stock instrument is a redeemable security subject to the subsequent-measurement guidance in ASC 480-10-S99-3A. In these circumstances, the carrying amount of the preferred stock host contract must also be remeasured in accordance with the recognition and measurement guidance in ASC 480-10-S99-3A immediately before redemption accounting is applied.
-
Conversion accounting — Since the settlement occurred in accordance with the contractual conversion terms, it is treated in the same manner as a conversion of convertible preferred stock that has no separately recognized amount for the embedded conversion option. Common stockholders’ equity is increased by the sum of the carrying amount of the preferred stock host and embedded conversion option liability. As with the accounting for a conversion when the embedded conversion option is not separated from the hybrid convertible preferred stock instrument, ASC 260-10-S99-2 does not apply to the settlement. However, if the convertible preferred stock instrument is classified in temporary equity and is being remeasured to its redemption amount, an adjustment in accordance with the entity’s accounting policy for remeasuring redeemable securities under ASC 480-10-S99-3A should be recognized immediately before conversion accounting is applied.
-
Partial redemption/partial conversion accounting — This view underscores aspects of both redemption accounting and conversion accounting. Any unamortized discount on the preferred stock host contract is immediately amortized into retained earnings and considered a “deemed dividend” that reduces net income in arriving at income available to common stockholders. This approach is consistent with the accounting for a conversion of convertible preferred stock that contains a separately recognized equity component. Common stockholders’ equity is then increased by the sum of the carrying amounts of the preferred stock host contract and separated embedded conversion option liability in a manner similar to the accounting for a conversion. Under this approach, if no unamortized discount remains on the host contract, no adjustment will be needed upon settlement for the redemption accounting aspect. Further, if the convertible preferred stock is a redeemable security that is being remeasured to its redemption amount under ASC 480-10-S99-3A, an entity should remeasure the carrying amount of the preferred stock host contract in accordance with the recognition and measurement guidance in ASC 480-10-S99-3A immediately before accounting for the settlement of the instrument.
Section
3.2.2.6.2.1.1 discusses the EPS accounting for a redemption of
convertible preferred stock that contains a separately recognized embedded
conversion option derivative liability.
3.2.2.5.4.2 Convertible Preferred Stock That Contains a Separately Classified Equity Component
Section
3.2.5.2.4 discusses the EPS accounting for a settlement of convertible
preferred stock that contains a separately classified equity component related to
the embedded conversion option when the settlement is considered a “conversion.” As
discussed in that section, upon conversion, any remaining unamortized discount on
the convertible preferred stock should be immediately recognized as a dividend,
which reduces net income in arriving at income available to common stockholders. The
adjusted carrying amount of the convertible preferred stock and the carrying amount
of the separately recognized equity component should then be recognized in
stockholders’ equity to reflect the conversion. This entry has no impact on income
available to common stockholders. The accounting upon conversion will also be
affected by the application of ASC 480-10-S99-3A if the convertible preferred stock
instrument is a redeemable equity security that is subject to the
subsequent-measurement guidance in ASC 480-10-S99-3A. See further discussion in
Sections 3.2.5.2.4 and 3.2.5.2.5.
3.2.2.6 Redemption or Induced Conversion of Preferred Stock
3.2.2.6.1 General
ASC 260-10 — SEC
Materials — SEC Staff Guidance
SEC Staff Announcement: The Effect on the Calculation of Earnings per Share for
a Period That Includes the Redemption or Induced Conversion of Preferred
Stock
S99-2 The following is the text of SEC Staff
Announcement: The Effect on Calculation of Earnings per Share for a Period
That Includes the Redemption or Induced Conversion of Preferred Stock.
Scope
This SEC staff announcement applies to redemptions
and induced conversions of equity-classified preferred stock
instruments. For purposes of this announcement:
-
Modifications and exchanges of preferred stock instruments that are accounted for as extinguishments, resulting in a new basis of accounting for the modified or exchanged preferred stock instrument, are considered redemptions.
-
A preferred stock instrument classified within temporary equity pursuant to the guidance in ASR 268 and paragraph 480-10-S99-3A is considered equity-classified, and redemptions and induced conversions of such securities would be subject to this guidance.
-
If an equity-classified security is subsequently required to be reclassified as a liability based on the provisions of other GAAP (for example, because a preferred share becomes mandatorily redeemable pursuant to Subtopic 480-10), the reclassification is considered a redemption of equity by issuance of a debt instrument.
The accounting for conversions of preferred stock
instruments into other equity-classified securities pursuant to
conversion privileges provided in the terms of the instruments at
issuance is not affected by this announcement.
The Effect on Income
Available to Common Stockholders of a Redemption or Induced Conversion
of Preferred Stock
If a registrant redeems
its preferred stock, the SEC staff believes that the difference between
(1) the fair value of the consideration transferred to the holders of the
preferred stock and (2) the carrying amount of the preferred stock in the
registrant’s balance sheet (net of issuance costs) should be subtracted
from (or added to) net income to arrive at income available to common
stockholders in the calculation of earnings per share. 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. This
calculation guidance applies to redemptions of convertible preferred stock
regardless of whether the embedded conversion feature is “in-the-money” or
“out-of-the-money” at the time of redemption. The fair value of the
consideration transferred is reduced by the commitment date intrinsic
value of the conversion option if the redemption includes the
reacquisition of a previously recognized beneficial conversion feature in
a convertible preferred stock instrument.
If
convertible preferred stock is converted into other securities issued by
the registrant pursuant to an inducement offer, the SEC staff believes
that the excess of (1) the fair value of all securities and other
consideration transferred in the transaction by the registrant to the
holders of the convertible preferred stock over (2) the fair value of
securities issuable pursuant to the original conversion terms should be
subtracted from net income to arrive at income available to common
stockholders in the calculation of earnings per share. Registrants should
consider the guidance provided in Subtopic 470-20 to determine whether the
conversion of preferred stock is pursuant to an inducement
offer.
The scope of ASC 260-10-S99-2 includes the following two types of
transactions:
- Redemptions of preferred stock, which include any of the following:
- A redemption or other settlement of a preferred stock instrument that is classified in equity (whether permanent equity or temporary equity) in return for cash, other securities issued by the entity, or other consideration, including a redemption or other settlement of a convertible preferred stock instrument that is classified in equity, regardless of whether the embedded conversion option is in-the-money or out-of-the-money on the settlement date.
- A redemption or other settlement of a derivative instrument indexed to a preferred stock instrument that is classified in equity in return for cash, other securities issued by the entity, or other consideration.
- A modification or exchange of a preferred stock instrument classified in equity (whether permanent equity or temporary equity) that is treated as an extinguishment.
- A modification or exchange of a freestanding or embedded equity-classified derivative indexed to a preferred stock instrument that is treated as an extinguishment.
- A reclassification of a preferred stock instrument, including a freestanding derivative indexed to such an instrument, from equity to a liability.
- Induced conversions of convertible preferred stock instruments classified in equity (whether permanent equity or temporary equity).
ASC 260-10-S99-2 does not address the accounting for any of the
following transactions:
- A conversion of a convertible preferred stock instrument in accordance with its stated conversion privileges.6
- A modification or exchange of a preferred stock instrument that is classified in equity (whether permanent equity or temporary equity) that is not treated as an extinguishment, including a modification or exchange of a freestanding or embedded derivative instrument indexed to a preferred stock instrument that is classified in equity that is not treated as an extinguishment.
- A redemption, modification, exchange, conversion, or other settlement of common stock.
- A redemption, modification, exchange, exercise, or other settlement of a freestanding financial instrument that is indexed to common stock and classified in equity.
- A redemption, modification, exchange, conversion, exercise, or other settlement of an embedded derivative indexed to common stock that has an associated amount classified in equity.7
- A redemption, modification, exchange, conversion, or other settlement of an embedded derivative indexed to common stock that is not separated from a hybrid financial instrument.
- A redemption, modification, exchange, conversion, or other settlement of any liability-classified instrument (e.g., convertible debt).
For transactions not within the scope of ASC 260-10-S99-2, an entity
should consider other relevant guidance to determine the effect, if any, on net income
or income available to common stockholders. Section 3.2 discusses transactions subject to ASC
260-10-S99-2 as well as certain transactions that are not subject to ASC 260-10-S99-2.
Although the requirement in ASC 260-10-S99-2 specifically concerns SEC registrants,
nonregistrants that present EPS should also apply it.
The table below summarizes the types of transactions involving
preferred stock that are considered redemptions to which ASC 260-10-S99-2 would be
applied.
Table
3-5
Instrument
| Transaction | Considered
Redemption Requiring Application of ASC 260-10-S99-2? |
---|---|---|
Preferred stock classified in permanent or temporary equity | Extinguishment for
cash, other assets, or shares not pursuant to a “conversion” in accordance
with the stated conversion privileges:
| Yes. |
Modification or
exchange that is accounted for as an extinguishment. | Yes. | |
Modification or exchange that is not accounted for as an
extinguishment. | No. ASC 260-10-S99-2 does not apply to a modification or
exchange of an equity-classified preferred stock instrument that is not
accounted for as an extinguishment. However, a similar concept is applied
when the modification or exchange provides incremental value to the
preferred stockholder. See Section
3.2.6.1 for considerations related to the impact on EPS for a
modification or exchange of preferred stock that is not accounted for as
an extinguishment. | |
Reclassification
from equity to a liability. | Yes. | |
Conversion into common stock according to the stated conversion
privileges that is considered a “conversion.” | No. However, if the conversion is considered an induced conversion,
the guidance in ASC 260-10-S99-2 on induced conversions applies (see
Section
3.2.2.6.3). See also Sections 3.2.5.2.4 and 3.2.5.2.5 if the
preferred stock contains a separately recognized equity
component. | |
Preferred stock classified as liability | Extinguishment for
cash, other assets, or shares not pursuant to “conversion” in accordance
with the stated conversion privileges:
| No. ASC 405-20 and ASC 470-50 provides accounting and
reporting guidance on extinguishments of liabilities. |
Modification or
exchange that is accounted for as an extinguishment. | No. ASC 470-50 provides accounting and reporting guidance on
modifications and exchanges of liabilities. | |
Modification or
exchange that is not accounted for as an extinguishment. | No. ASC 470-50 provides accounting and reporting guidance on
modifications and exchanges of liabilities. | |
Conversion into
common stock according to the stated conversion privileges that is
considered a “conversion.” | No. ASC 470-20 provides accounting and reporting guidance on the
conversion of convertible debt into common stock. That guidance also
addresses the accounting for induced conversions. |
3.2.2.6.2 Redemption of Preferred Stock
In a redemption of preferred stock that is classified in permanent
or temporary equity, any difference between the fair value of consideration
transferred to redeem the preferred stock and the net carrying amount of the preferred
stock on the issuer’s balance sheet will affect net income available to common
stockholders regardless of whether the redemption is at a premium or a discount to the
net carrying amount. The SEC staff believes that this difference 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 (i.e., a “deemed dividend” or a “deemed
contribution”). If the fair value of the consideration transferred exceeds the net
carrying amount of the preferred stock, the excess consideration (the premium paid)
represents a return to the preferred stockholders and is deducted from net income to
arrive at income available to common stockholders (a “deemed dividend”). If the fair
value of the consideration transferred is less than the net carrying amount of the
preferred stock, the discount is added to net income in arriving at income available
to common stockholders (a “deemed contribution”).
The table below addresses certain matters related to the redemption of preferred
stock.
Issue
|
Application
|
---|---|
Scope
|
The SEC staff’s view on redemptions of preferred stock in ASC
260-10-S99-2, must be applied to all extinguishments of preferred stock by
SEC registrants. It should also be applied by nonregistrants that report
EPS under ASC 260.
ASC 260-10-S99-2 applies to the redemption of
convertible preferred stock regardless of whether the conversion feature
is “in-the-money” or “out-of-the-money” as of the redemption date (see
Section 3.2.2.6.2.1). ASC
260-10-S99-2 also applies to the reclassification of preferred stock as a
liability (see Sections 3.2.2.8 and
3.2.3.5.1) and the redemption of
preferred stock that is classified as an NCI (see Sections 3.2.3.2.1 and 3.2.3.3.1).
|
Consideration transferred to redeem preferred stock
|
Under ASC 260-10-S99-2, it is presumed that the fair value of the
consideration transferred to holders to redeem a preferred stock
instrument reflects the fair value of the preferred stock that is being
redeemed. If the fair value of the consideration transferred to preferred
stockholders 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.
Publicly traded companies that repurchase preferred
stock may be obligated to pay a 1 percent excise tax under Internal
Revenue Code (IRC) Section 4501, which was added by the Inflation
Reduction Act of 2022. This excise tax should be included in the
adjustment to retained earnings that is recognized for the redemption of
the preferred stock in accordance with ASC 260-10-S99-2. See Deloitte’s
April 27, 2023, Heads
Up for more information about the accounting for this
excise tax.
|
Net carrying amount of preferred stock redeemed
|
Direct issuance costs capitalized at issuance of preferred stock —
Under ASC 260-10-S99-2, the net carrying amount of preferred stock, which
is used to calculate the adjustment to the numerator upon a redemption of
preferred stock, must include issuance costs that were capitalized into
the initial carrying amount of preferred stock. Such costs reduce the net
carrying amount of the preferred stock, and the excess of the
consideration transferred over this adjusted net carrying amount reduces
net income in arriving at income available to common stockholders in the
calculation of basic EPS. Because most entities have capitalized issuance
costs associated with preferred stock, the numerator in the calculation of
basic EPS will generally be adjusted in the period of a redemption of
preferred stock unless the preferred stock has already been remeasured to
its redemption amount under ASC 480-10-S99-3A (see Section 3.2.2.6.2.2).
Undeclared cumulative dividends — To calculate
the adjustment to net income to arrive at income available to common
stockholders upon a redemption of preferred stock, an entity should add
any undeclared cumulative dividends previously considered in the
calculation of basic EPS to the net carrying amount of the preferred stock
being redeemed when such amounts are not already included in the net
carrying amount of the preferred stock. In other words, when the
redemption price includes the payment of accumulated but undeclared
cumulative dividends that have already been included in the calculation of
income available to common stockholders in a prior period but that are not
recognized as part of the net carrying amount of the preferred stock on
the issuer’s balance sheet, an adjustment must be made to the excess of
the fair value of consideration transferred over the net carrying amount
of the preferred stock so that the impact of such cumulative dividends is
not “double counted.”
Declared and unpaid dividends (whether cumulative or not) — If an
entity has recognized a liability for accrued and unpaid declared
dividends, the carrying amount of this liability should be included with
the net carrying amount of the preferred stock in calculating the “deemed
dividend” or “deemed contribution” that adjusts net income to arrive at
income available to common stockholders.
Redeemable preferred stock — For a redemption of redeemable
preferred stock that is being remeasured to its redemption amount under
ASC 480-10-S99-3A, the net carrying amount should be adjusted immediately
before the redemption in accordance with the entity’s accounting for
remeasurement adjustments under ASC 480-10-S99-3A (see Section 3.2.2.6.2.2).
Convertible preferred stock with a separated embedded conversion
liability — See Section
3.2.2.6.2.1.1.
Convertible preferred stock with a separated equity component —
See Section 3.2.2.6.2.1.2.
|
Modification of preferred stock that is treated as an extinguishment |
An entity may incur fees and costs in a modification or exchange of
preferred stock that is treated as an extinguishment. Such fees and costs
should be treated in the same manner as that described in ASC 470-50-40-17
and 40-18 for modifications and exchanges of debt instruments that are
accounted for as extinguishments. Therefore, fees and costs incurred with
third parties should be capitalized into the carrying amount of the “new”
preferred stock instrument and fees and costs incurred with investors
should be considered associated with the “original” preferred stock
instrument and included as part of the charge (or credit) to retained
earnings for the extinguishment of the original preferred stock
instrument.
See Section
3.2.6.1 for more information about modifications and
exchanges of preferred stock.
|
Below are some examples illustrating the application of ASC
260-10-S99-2 to redemptions of preferred stock.
Example
3-8
Reacquisition of Preferred Stock on Open Market
Company B has 100,000 shares of outstanding
preferred stock that is not mandatorily redeemable but may be called at
B’s option at a price of $1,100 per share. Each outstanding share has a
liquidation preference of $1,000. The outstanding preferred stock has an
aggregate liquidation preference of $100 million and an aggregate net
carrying amount of $98 million (or $980 per share). The difference between
the aggregate liquidation preference and net carrying amount results from
capitalized issuance costs.
The preferred stock is currently trading at $1,075 per share. Company B has
recently issued other securities for which it plans to use those proceeds
to redeem the outstanding preferred stock. Since it is economically
favorable to B to repurchase the preferred stock in the open market in
lieu of exercising its redemption option, B acquires 50,000 shares of the
outstanding preferred stock for an aggregate price of $54 million, or
(50,000 shares × 1,075) + $250,000 in transaction costs.
Company
B’s “reacquisition” should be treated as a redemption of preferred stock
under ASC 260-10-S99-2 since this guidance applies to all types of
redemptions of preferred stock. The adjustment to income available to
common stockholders required for the redemption of the 50,000 shares of
preferred stock is a $5 million charge. This is treated in the same manner
as the payment of a dividend on preferred stock. The $5 million reduction
from net income to arrive at income available to common stockholders is
calculated as follows:
The
$5 million should not be recognized as a loss in the income statement;
rather, it is reflected as a reapportionment of equity between common
stockholders and preferred stockholders. The $5 million will, however,
have the same impact as a loss on the numerator in the calculation of
basic EPS.
Example
3-9
Reclassification of Preferred Stock From Equity to Liability
Company D has outstanding preferred stock with the
following terms:
- The preferred stock is automatically converted into common stock at a conversion price of $25 per share in the event that D effects a qualified IPO within the next five years.
- If D does not effect a qualified IPO by the end of the fifth year from the issuance date, the preferred stock becomes mandatorily redeemable in five years.
Company D should not classify the preferred
stock as a liability under ASC 480 before the fifth year from the issuance
date if it concludes that the conversion upon a qualified IPO is a
substantive feature. Furthermore, while D is required to classify the
preferred stock within temporary equity under ASC 480-10-S99-3A, it should
not remeasure the preferred stock to its redemption amount as long as the
occurrence of a qualified IPO by the end of year five is more than remote.
However, if a qualified IPO does not happen by the
end of year five, the preferred stock becomes a mandatorily redeemable
financial instrument for which reclassification as a liability is required
under ASC 480. In this circumstance, in accordance with ASC 480-10-30-2, D
should reflect the reclassification by measuring the liability initially
at fair value and reducing equity by the same amount without recognizing a
gain or loss. This reclassification is treated in the same manner as any
other extinguishment of preferred stock under ASC 260-10-S99-2. Therefore,
the difference between the initial fair value amount recognized for the
preferred stock upon reclassification as a liability and the net carrying
amount of the preferred stock (which should be adjusted under other
applicable GAAP, including ASC 480-10-S99-3A if applicable, immediately
before such reclassification) reflects a charge (or credit) to net income
in arriving at income available to common stockholders. See Section 3.2.2.8 for
further discussion of the reclassification of preferred stock to a
liability.
Example
3-10
Redemption of Subsidiary’s Preferred Stock by Parent
Company P has a wholly owned subsidiary, S, that has
outstanding Series A preferred stock held by third parties. The relevant
features of the Series A preferred stock are as follows:
- Dividends on the preferred stock are cumulative.
- The preferred stock is not mandatorily redeemable and therefore is not classified as a liability under ASC 480-10-25-4.
- The preferred stock is not redeemable at the option of the holder or upon the occurrence of any event outside S’s control and therefore is not classified in temporary equity.
- The preferred stock is redeemable, in whole or in part, on various dates at S’s option, with P’s consent. The redemption price is equal to fixed prices depending on the redemption date, plus any accrued and unpaid cumulative dividends up to the date of redemption. The fixed prices include a premium to the original issuance price.
In accordance with ASC 810-10-45-16, the Series A preferred stock is classified
as an NCI and is reported in permanent equity, separately from parent
equity, in P’s consolidated balance sheet. Company P treats dividends on
the preferred stock as income attributable to the NCI in its consolidated
income statement.
Company P is contemplating having S exercise its redemption option, which will
result in the redemption of the Series A preferred stock at a premium over
the net carrying amount. Because P is not required to remeasure the
preferred stock to its redemption amount under ASC 480-10-S99-3A or other
GAAP, before a redemption, P is not required to recognize the premium
payable on a redemption in its consolidated financial statements. Rather,
any redemption will be treated as a capital stock transaction under ASC
810-10-40-1 and 40-2. Thus, before redemption, the only impact that S’s
Series A preferred stock has on P’s basic EPS pertains to the dividends
that accumulate, which are being recognized in P’s consolidated income
statement as income attributable to the NCI, as stated above.
If S’s Series A preferred stock is redeemed, net income should be reduced, in
P’s consolidated financial statements, by the amount of the premium paid
to redeem the preferred stock to arrive at income available to common
stockholders. The adjustment to net income to arrive at income available
to common stockholders should be calculated as the fair value of the
consideration paid to extinguish the Series A preferred stock (which
includes the premium but not dividends that were previously recognized as
income attributable to NCI) over the net carrying amount of the preferred
stock as reported in NCI.
Under ASC 810, distributions to equity holders, including NCI holders, acting in
their capacity as owners should be excluded from the determination of the
consolidated entity’s net income. However, ASC 810 does not specifically
address whether the parent should treat dividends on a subsidiary’s
preferred stock as an attribution of the subsidiary’s income to the NCI or
as a direct adjustment to retained earnings. On the basis of informal
discussions with the FASB staff, we believe that there are two acceptable
alternatives for presenting dividends on a subsidiary’s preferred stock in
the parent’s consolidated income statement:
-
Alternative 1 — The parent presents the subsidiary’s preferred dividends as a component of the attribution of net income to the NCI on the face of the consolidated statement of income. The preferred dividends result in a decrease in consolidated net income attributable to the parent.
-
Alternative 2 — The parent treats the subsidiary’s preferred dividends as a direct adjustment when calculating income available to the parent’s common stockholders. The preferred dividends do not affect the reported amount of consolidated net income attributable to the parent, which is consistent with the accounting for dividends on preferred stock issued by the parent.
The parent should consistently apply the alternative it selects and should
consider disclosing its accounting policy under ASC 235-10-50. In this
example, assume that P has elected Alternative 1.
Under either alternative, the subsidiary’s preferred dividends will have the
same impact on income available to the parent’s common stockholders, which
is the numerator used in the consolidated entity’s EPS calculation. The
above guidance also applies to a subsidiary’s preferred securities that
are classified in temporary equity under ASC 480-10-S99-3A. The
alternative selected should also be applied to remeasurement adjustments
under ASC 480-10-S99-3A. For more information about the two alternatives,
see Section
6.8 of Deloitte’s Roadmap Noncontrolling Interests.
In this example, the premium on redemption of S’s Series A preferred stock
represents a return on investment to the holders of the preferred stock
that is not available to common stockholders and affects P’s basic EPS in
the same manner as the dividends on S’s Series A preferred stock. However,
since P presents dividends on S’s Series A preferred stock as part of
income attributable to the NCI, which reduces P’s consolidated net income,
the dividends and the premium on redemption are presented differently. The
premium on redemption is not treated as an allocation of income
attributable to NCI. This guidance is consistent with that in ASC
260-10-S99-2.
3.2.2.6.2.1 Redemption of Convertible Preferred Stock
As discussed in ASC 260-10-S99-2, in a redemption of convertible
preferred stock, the difference between the fair value of the consideration
transferred and the net carrying amount of the convertible preferred stock must be
deducted from net income in arriving at income available to common stockholders,
regardless of whether the embedded conversion feature is “in-the-money” or
“out-of-the-money” at the time of redemption.
Connecting the Dots
A convertible preferred stock instrument may be redeemed on
the basis of a price negotiated between the issuer and the investor. The
negotiated price will be affected by whether the conversion option is
“in-the-money” or “out-of-the-money” on the date the redemption price is agreed
upon. Provided that the convertible preferred stock instrument does not contain
any separately recognized derivative liability or equity components, the
conversion of the instrument into common stock in accordance with the stated
conversion privileges would have no impact on the numerator in the calculation
of basic EPS. Furthermore, the issuer could use cash to repurchase the shares of
its common stock issued on conversion in open market transactions without having
any impact on income available to common stockholders. The combination of the
conversion and open market share repurchase may achieve the same or a similar
economic outcome as redeeming the convertible preferred stock instrument with
the holder for cash. However, even though the economics may be the same or
similar, it is not appropriate to account for a redemption as comprising a
conversion and then a subsequent repurchase of the common stock. Rather, the
redemption must result in a charge (or credit) in the calculation of income
available to common stockholders. The example below illustrates this
concept.
Example
3-11
Redemption of Convertible Preferred Stock That
Contains an “In-the-Money” Conversion Option
Assume the following:
- Company X has preferred stock outstanding with a carrying value of $40 million.
- Company Y, the holder of the preferred stock, has the right to convert the preferred stock into 1.7 million shares of X’s common stock. Further, Y has the option to require X to redeem the preferred stock during a five-year period at rates declining ratably from 110 percent of par value plus unpaid cumulative dividends in the first year to 100 percent of par value in the fifth year.
- The current market value of the common stock is significantly higher than the redemption price of the preferred stock. Therefore, X expects Y to convert its preferred stock into the 1.7 million shares of common stock. Company Y has indicated that it intends to sell the common stock on conversion.
- Because of the effect such a large block of stock would have on the market price of X’s common stock if it were sold, X has agreed to pay Y the market price of the common stock in return for the preferred stock.
- The embedded conversion option in the convertible preferred stock has not been separated from the hybrid financial instrument.
Although the economic effect of the
transaction is similar to what would be achieved on Y’s conversion of
its preferred stock followed by X’s reacquisition of such shares as
treasury stock, the transaction is viewed as the redemption of preferred
stock. ASC 260-10-S99-2 stipulates that, for EPS purposes, the
difference between the fair value of the cash consideration paid to Y
and the net carrying amount of the preferred stock should be accounted
for as a reduction of net income in arriving at income available to
common stockholders.
The Codification does not explicitly address whether a settlement
of convertible preferred stock in accordance with a stated settlement provision in a
preferred stock agreement constitutes a conversion or a redemption. While an entity
may need to use judgment and consider the particular facts and circumstances in
determining whether a settlement of convertible preferred stock reflects a
conversion or redemption, certain guidance in ASC 470-20 on evaluating the
settlement of a debt instrument is relevant to this determination by analogy.
Specifically, ASC 470-20-40-5 indicates that the issuance of equity securities such
as common stock in accordance with an instrument’s original conversion terms to
settle a debt instrument that becomes convertible upon the issuer’s exercise of a
call option should be treated as a conversion if the instrument contained a
substantive conversion feature as of its issuance date; otherwise, the issuance of
equity securities should be accounted for as an extinguishment (i.e., a redemption).
For convertible preferred stock, an entity evaluates whether settlement occurred in
accordance with the terms of a substantive conversion feature by considering the
monetary value of the consideration (i.e., the payoff profile) as opposed to the
form of consideration (i.e., shares of common stock or cash). For example, some
convertible preferred stock instruments contain embedded “conversion terms” that
are, in essence, redemption features that are settled by delivery of a variable
number of shares of common stock. It is important for an entity to distinguish
between embedded features that are conversion options and those that are redemption
options since ASC 260-10-S99-2 applies to redemptions of preferred stock even if the
consideration transferred to redeem the shares is common stock of the issuer. That
is, a “conversion term” that results in the delivery of a variable number of shares
of common stock with a fixed monetary amount should be treated as a redemption.
Examples 3-12 through 3-14 illustrate the
treatment of settlements of convertible preferred stock in accordance with the
contractual terms of embedded features.
Example
3-12
Settlement of Convertible Preferred Stock With a
Fixed-Price Conversion Feature and a Fixed-Percentage Conversion
Feature
Company J has $10 million of
preferred stock outstanding with the following conversion terms:
- At any point after five years from the issuance date, the holder can convert the preferred stock into shares of common stock at a conversion price of $25 per share (the “fixed-price conversion feature”).
- At any point after five years from the issuance date, the issuer can settle the preferred stock by issuing a number of shares of common stock that has a fair value equal to the liquidation preference of the convertible preferred stock, divided by 90 percent and rounded to the closest number of whole shares (the “fixed-percentage conversion feature”). If the issuer elects to exercise this redemption feature, the holder has the right to elect to exercise its conversion option.
Company J has concluded that the preferred stock does not need to be classified
as a liability under ASC 480 and has analyzed the conversion terms as
consisting of an embedded conversion option with respect to the
fixed-price conversion feature and an embedded call option with respect
to the fixed-percentage conversion feature. Further, J has concluded
that it is not required to separate either of these embedded features
under ASC 815-15.
Below is an analysis of J’s EPS accounting depending on which conversion feature
constitutes the terms of the settlement of the convertible preferred
stock.
Scenario 1 — Fair Value of
Common Stock Is $30 per Share
In
this scenario, each holder will receive the following number of shares
of common stock under each feature:
Fixed-price
conversion feature | 40
shares | ($1,000 ÷ $25 = 40
shares) |
Fixed-percentage
conversion feature | 37
shares | ($1,000 ÷ 0.9 =
$1,111 ÷ $30 = 37 shares) |
The holder will elect to exercise its fixed-price conversion feature since doing
so is economically favorable. This settlement reflects a “conversion” in
accordance with the original conversion privileges of the convertible
preferred stock. ASC 260-10-S99-2 does not
apply.
Scenario 2 — Fair Value of
Common Stock Is $26 per Share
In this
scenario, each holder will receive the following number of shares of
common stock under each feature:
Fixed-price
conversion feature | 40
shares | ($1,000 ÷ $25 = 40
shares) |
Fixed-percentage
conversion feature | 43
shares | ($1,000 ÷ 0.9 =
$1,111 ÷ $26 = 43 shares) |
The holder will not elect to exercise its fixed-price conversion feature because
that would be economically unfavorable; therefore, settlement will occur
on the basis of the fixed-percentage conversion feature (provided that
the issuer elects to exercise its redemption option). This settlement
reflects a “redemption” of the convertible preferred stock. ASC
260-10-S99-2 does apply. When ASC 260-10-S99-2
is applied, the fair value of the consideration transferred that is used
in calculating the adjustment to arrive at income available to common
stockholders is $1,111 per share of preferred stock extinguished (i.e.,
43 shares × $26 per share = $1,111). Even though a conversion would have
provided the holder with a return of $40 per share of preferred stock,
which is calculated as ($26 per share – $25 per share) × 40 shares =
$40, it would not be appropriate to consider the fair value of the
consideration transferred to redeem the preferred stock to be $1,111
less $40 per share.
The
conclusions in this example would be unchanged if it was the holder, as
opposed to the issuer, that had the right to exercise the
fixed-percentage conversion feature.
Example
3-13
Settlement of Redeemable Convertible Preferred Stock
in Cash on the Basis of (1) Exercise of Conversion Option or (2)
Exercise of Redemption Option
Assume the
following facts:
- Company H, a nonpublic entity, has issued $25 million of Series B redeemable convertible preferred stock (the “Series B stock”) at its liquidation amount.
- The Series B stock contains dividends, payable in cash, that are cumulative and accrue at an annual rate of 8 percent.
- The holders of the Series B stock can convert the shares at any time at a fixed conversion rate of 25 shares of H’s common stock per $1,000 liquidation amount of Series B stock. Conversion automatically occurs upon a qualified IPO of H. Company H has the right to elect to settle conversion either entirely in shares of common stock or entirely in cash of an equivalent value. Further, H has sufficient authorized and unissued common shares to settle conversions in shares.
- The holders of the Series B stock also have the right to redeem the shares at any time after five years from the issuance date at an amount equal to 102 percent of the liquidation amount per share redeemed, plus any accrued and unpaid cumulative dividends, regardless of whether the dividends are declared. Settlement may occur either entirely in cash or entirely in a variable number of shares of H’s common stock with the same monetary value as the cash settlement amount at the option of the holder.
- Company H has the right to redeem the Series B stock at any time after five years from the issuance date at an amount equal to 110 percent of the liquidation amount per share redeemed, plus any accrued and unpaid cumulative dividends, regardless of whether the dividends are declared. Settlement may occur either entirely in cash or entirely in a variable number of shares of H’s common stock with the same monetary value as the cash settlement amount at the option of H.
- The Series B stock does not participate in dividends on H’s common stock and did not contain a separated equity component.
- Company H has determined that the host contract for the Series B stock is an equity instrument. The embedded conversion feature has not been separated as an embedded derivative because it is considered clearly and closely related to the host contract under ASC 815-15. Neither of the redemption options have been separated from the Series B stock under ASC 815-15 because they must be physically settled and the Series B stock is not readily convertible to cash.
- The Series B stock meets the conditions for classification in temporary equity, and H has applied the guidance in ASC 480-10-S99-3A in its financial statements included in a Form S-1 registration statement filed for an IPO. Because H has deemed a qualified IPO as being reasonably possible before the holders can redeem the shares and controls the ability to settle the Series B stock in common stock upon any conversion, the Series B stock is not remeasured to its redemption amount.
- Because H’s financial statements are included in a registration statement filed with the SEC, H presents basic and diluted EPS.
Scenario 1 —
Settlement of Conversion Option
If
settlement of the Series B stock occurs through exercise of the
conversion option, ASC 260-10-S99-2 does not
apply, regardless of whether the form of settlement is cash or
shares of H’s common stock. Since H controls the form of settlement upon
conversion, H is also not required to recognize any adjustments to net
income under ASC 480-10-S99-3A.
While the Series B stock was not being remeasured to its redemption amount, if
the facts were different, the Series B stock may need to be remeasured
to its redemption amount under ASC 480-10-S99-3A. For example, assume
the same facts as described above except that the holders, rather than
H, had the right to elect to settle any conversion in cash in lieu of
shares of common stock. In this circumstance, H would be required to
remeasure the Series B stock to the maximum amount of cash payable
pursuant to the conversion feature or put feature in accordance with its
accounting policy applied under ASC 480-10-S99-3A. The remeasurement
adjustment would be treated as a “deemed dividend” under ASC
480-10-S99-3A that would have an impact on the numerator in the
calculation of basic EPS.
As another example,
assume the same facts as described above except that the Series B stock
was not mandatorily converted into common stock upon a qualified IPO. In
this circumstance, the Series B stock would have needed to be
periodically remeasured to its redemption amount under ASC 480-10-S99-3A
because the holders control the ability to “put” the Series B stock for
cash and not convert it into common stock. Therefore, H would be
required to make a remeasurement adjustment in accordance with its
accounting policy applied under ASC 480-10-S99-3A. That amount, which
would be calculated on the basis of the redemption price underlying the
holders’ put option, would be treated as a “deemed dividend” in the
calculation of basic EPS. Thus, while ASC 260-10-S99-2 would not apply,
the application of ASC 480-10-S99-3A would have still resulted in a
reduction of net income in arriving at income available to common
stockholders; however, the amount of the adjustment would not have been
the same as the adjustment that would have been made if ASC 260-10-
S99-2 had applied to the conversion.
The above
alternatives illustrate the need for an entity to closely consider the
terms and features of preferred stock so that it can appropriately apply
ASC 480-10-S99-3A and ASC 260-10-S99-2.
Scenario 2 — Settlement of Redemption Option
If the Series B stock is settled through exercise of either of the redemption
options, ASC 260-10-S99-2 does apply regardless
of whether the form of settlement is cash or shares of H’s common stock.
In calculating the difference between the redemption price and the net
carrying amount of the Series B stock, H should exclude the portion of
the redemption price that pertains to unpaid cumulative dividends that
have already been included as adjustments to net income in arriving at
income available to common stockholders in prior reporting periods.
Example
3-14
Preferred Equity Redemption Cumulative Stock
Preferred equity redemption cumulative stock
(PERCS) is a form of equity instrument that is automatically converted
into shares of common stock on the mandatory conversion date or upon the
occurrence of certain other specified events (e.g., a merger,
consolidation, or similar extraordinary transaction). The issuer has the
option of calling the PERCS at any time before the mandatory conversion
date for a specified call price payable in the issuer’s common stock.
The call price may decline ratably during the period leading up to the
mandatory conversion date.
PERCS is generally
issued at a price equal to the issuer’s common stock price and, upon
mandatory conversion, is exchanged one-for-one for common stock.
However, the investor’s upside potential is “capped” (generally at a
level 30–35 percent over the initial issuance price) because the issuer
can call the PERCS by delivering fewer common shares to the extent that
the cap has been exceeded. In other words, the investor will receive one
common share in exchange for each PERCS share provided that the issuer’s
common stock price is less than or equal to the capped price. If the
issuer’s common stock price exceeds the “capped” price, the issuer will
call the instrument and the investor will receive a variable number of
shares of common stock that has a monetary value equal to the “capped”
price. Thus, upon any call, the investor will always receive less value
than it would have received in a conversion.
Generally, the PERCS investor receives a dividend during the period in
which the PERCS is outstanding and the dividend is higher than the
dividend on the issuer’s common stock. Such a dividend compensates the
investor for its limited ability to participate in the appreciation of
the common stock as a result of the call option. In substance, the PERCS
investor owns the underlying common stock and the issuer holds a call
option on this stock.
For example, assume that
an entity issues 10 shares of PERCS at $30 per share for an aggregate
purchase price of $300 when the fair value of the issuer’s common stock
is also $30 per share. Further assume that the PERC has a capped price
of $40. Upon settlement, the investor would experience the following
outcomes if the fair value of the issuer’s common stock was $20 and $50,
respectively:
- If the fair value of the issuer’s common stock at maturity was $20 per share, the investor would receive 10 shares of common stock that has an aggregate monetary value of $200. Ignoring dividends paid during the term of the instrument, the investor realizes an economic loss of $100.
- If the fair value of the issuer’s common stock at maturity was $50 per share, the investor would receive only 8 shares of common stock because the issuer would call the instrument at $40 per share (i.e., $40 × 10 = $400 ÷ $50 per share = 8 shares). The eight shares received would have an aggregate fair value of $400. Ignoring dividends paid during the term of the instrument, the investor realizes an economic gain of $100.
The impact on the numerator in the calculation of basic EPS for the instrument
described above is as follows:
-
If the issuer settles the PERCS by delivering a number of shares of common stock equal to the number of shares of PERCS shares settled, the numerator is unaffected. This settlement is treated in the same manner as a conversion of preferred stock according to its stated terms, as discussed in Section 3.2.2.5.4. In this example, as long as the fair value of the issuer’s common stock is $40 per share or less, the settlement will be made by delivering one share of common stock for each PERCS share.
-
If the issuer settles the PERCS by delivering a variable number of shares of common stock that is less than the number of PERCS shares settled, the numerator is unaffected. That is, in an exchange of common stock for outstanding PERCS shares in which the number of shares of common stock exchanged is less than the number of shares of common stock issuable at the 1:1 conversion rate, the issuer is not required to recognize a charge to net income in arriving at income available to common shareholders. ASC 260-10-S99-2 would not be considered applicable in this circumstance because the issuer has, in substance, called underlying common stock at an amount less than fair value. Transactions in the issuer’s common stock between the date of issuance of the PERCS shares and the settlement date would not affect this conclusion provided that such transactions were not targeted to PERCS holders to affect the outcome of the settlement of the PERCS.
-
If the issuer settles the PERCS by paying cash, other assets, or securities other than its outstanding common stock, either directly with the holder or by repurchasing the PERCS on the open market, this would be considered a redemption of the PERCS and ASC 260-10-S99-2 must be applied. This conclusion is reached on the basis that the settlement of the PERCS occurred in a manner that was outside the contractual terms of the instrument.
The conclusion on the application of ASC
260-10-S99-2 to PERCS is based on the unique terms of the instrument and
should not be applied by analogy to other instruments with different
terms.
The next section discusses the EPS accounting for a redemption of
a preferred stock host contract and the separated embedded derivative conversion
option liability. Section
3.2.2.6.2.1.2 discusses the EPS accounting for a redemption of
convertible preferred stock that contains a separately recognized equity component.
Section 3.2.2.6.2.2
discusses the redemption of preferred stock, including convertible preferred stock,
that is classified in temporary equity and is being remeasured to its redemption
amount under ASC 480-10-S99-3A.
3.2.2.6.2.1.1 Convertible Preferred Stock That Contains an Embedded Conversion Option Accounted for as a Derivative Liability
When an entity has separated an embedded conversion option from
a convertible preferred stock instrument and accounted for the embedded conversion
option as a derivative liability under ASC 815-15, any redemption of the
convertible preferred stock instrument consists of a redemption of both the
preferred stock host contract and the embedded conversion option liability. The
redemption of the preferred stock host contract component is within the scope of
ASC 260-10-99-2. An entity should apply the following approach to allocate the
total consideration paid upon redemption between the preferred stock host contract
and the separated embedded conversion option liability:
- Step 1 — Remeasure the embedded conversion option liability to its fair value immediately preceding the redemption. Any change in fair value should be recognized in earnings in the financial reporting period that includes the redemption.
- Step 2 — If the convertible preferred stock instrument is a redeemable equity security that is subject to remeasurement under ASC 480-10-S99-3A, the entity should apply its accounting policy under ASC 480-10-S99-3A and adjust the carrying amount of the preferred stock host contract to its redemption amount as of the date of the redemption. Any adjustment is considered a “deemed dividend” for which net income is adjusted in arriving at income available to common stockholders in the financial reporting period that includes the redemption.
- Step 3 — Compare the fair value of the total consideration paid to redeem the convertible preferred stock instrument with the sum of the carrying amounts of the preferred stock host contract and embedded conversion option liability after those carrying amounts have been adjusted in steps 1 and 2.
- If the total consideration transferred to redeem the convertible preferred stock instrument equals the sum of the carrying amounts of the preferred stock host contract and embedded conversion option liability, there is no incremental amount to be recognized in either earnings or as a “deemed dividend” to account for the redemption.
- If the total consideration transferred to redeem the convertible preferred stock instrument does not equal the sum of the carrying amounts of the preferred stock host and embedded conversion option liability, an allocation of the total consideration transferred on redemption to these two components is required. The total consideration paid to redeem the convertible preferred stock instrument should first be allocated to the embedded conversion option liability in an amount that equals the carrying amount of that component producing no incremental gain or loss. The remaining amount of the total consideration paid to redeem the convertible preferred stock instrument should be allocated to the preferred stock host contract. Any difference between this allocated amount and the carrying amount of the preferred stock host contract is within the scope of ASC 260-10-S99-2. Therefore, this difference should be recognized as a charge (or credit) to net income in arriving at income available to common stockholders in the financial reporting period that includes the redemption.
The example below illustrates a redemption of convertible
preferred stock that contains a separated embedded conversion option liability.
Example
3-15
Redemption of Convertible Preferred Stock That
Contains a Bifurcated Conversion Option
Company Z has issued and has outstanding redeemable convertible
preferred stock. Further, Z remeasures the convertible preferred stock
to its redemption amount in each period under ASC 480-10-S99-3A as if
the balance sheet date is the redemption date. The embedded conversion
option in the convertible preferred stock has been separated as a
derivative liability under ASC 815-15 and is being measured at fair
value, with changes recognized in earnings. In determining the
adjustment needed under the subsequent-measurement guidance in ASC
480-10-S99-3A, Z compares the redemption price with the sum of the
carrying amounts of the host preferred stock and derivative liability
and recognizes an adjustment only if those aggregate amounts are less
than the current redemption amount.
Assume
that the convertible preferred stock is redeemed on March 1, 20X1, in
accordance with the terms of the redemption feature in the convertible
preferred stock. If Z accounts for the settlement in the following
order, there will be no additional amounts to recognize under ASC
260-10-S99-2:
- First, remeasure the derivative liability to fair value under ASC 820 as of March 1, 20X1, with the adjustment recognized in net income.
- Next, remeasure the preferred stock host contract to equal the excess of (1) the redemption amount over (2) the sum of the carrying amounts of the preferred stock host and derivative liability, as remeasured in step 1. This adjustment reflects a “deemed dividend” that affects basic EPS.
- Last, recognize the settlement of the convertible preferred stock. The fair value of the total consideration transferred to redeem the convertible preferred stock will equal the adjusted aggregate carrying amounts recognized for the convertible preferred stock, since it was redeemed according to the same contractual redemption feature used to adjust the carrying amount to the redemption amount.
While ASC 260-10-S99-2 does not result in
an incremental adjustment, the adjustment recognized in the second
step will be treated as a “deemed dividend” (or “deemed contribution”)
for which net income is adjusted in arriving at income available to
common stockholders.
3.2.2.6.2.1.2 Convertible Preferred Stock That Contains a Separately Classified Equity Component
A convertible preferred stock instrument will have a separately
classified equity component only in limited circumstances (e.g., as a result of
the recognition of a down-round feature). In these circumstances, the amount
separately recognized in equity will affect the accounting for the redemption of
the convertible preferred stock under ASC 260-10-S99-2 because the redemption
consists of both the previously recognized equity component and the net carrying
amount of the convertible preferred stock instrument. See Sections 3.2.5.2.4 and
3.2.5.2.5 for
additional discussion of the EPS accounting for a redemption of convertible
preferred stock containing a separately recognized equity component. That section
also discusses the impact of the accounting for a redemption on remeasurement
adjustments related to the convertible preferred stock instrument that are
recognized under ASC 480-10-S99-3A.
3.2.2.6.2.2 Redemption of Preferred Stock Subject to Remeasurement Under ASC 480-10-S99-3A
Preferred stock, including convertible preferred stock, may be
classified in temporary equity under ASC 480-10-S99-3A as a result of redemption
features that allow the holder to redeem the security or allow for redemption upon
the occurrence of events outside the issuer’s control, other than an ordinary
liquidation. Under ASC 480-10-S99-3A(14) and 3A(15), redeemable preferred stock must
be remeasured to its redemption amount either if it is currently redeemable or if it
is probable that it will become redeemable.
When an entity redeems preferred stock that is being remeasured to
its redemption amount under ASC 480-10-S99-3A, the entity should remeasure the
preferred stock to its redemption amount immediately before accounting for the
redemption. If the preferred stock is being remeasured to its current redemption
amount and the redemption occurs in accordance with the redemption provisions used
to remeasure the preferred stock, the application of ASC 260-10-S99-2 may not result
in any incremental adjustment to the numerator in the calculation of basic EPS.
Rather, the adjustments for the redemption terms of the preferred stock will affect
the numerator through the application of ASC 480-10-S99-3A (see Section 3.2.2.4). In other
cases, an adjustment may be required under ASC 260-10-S99-2 for the redemption of
preferred stock that is classified in temporary equity even if the preferred stock
is being remeasured to its redemption amount under ASC 480-10-S99-3A before the
redemption. The example below illustrates this point.
Example
3-16
Redemption of Redeemable Preferred Stock
Company Z issues $100 million of preferred stock to
various investors. The preferred stock has the following terms:
- Dividends are cumulative at a rate of 5 percent per annum.
- The preferred stock is redeemable at the holder’s option at any point after five years from the issuance date at a price of $105 per share, or an aggregate amount of $105 million, plus any accumulated dividends that have not been paid.
Company Z incurred direct costs of $5
million in issuing the preferred stock.
Because
the preferred stock is redeemable at the option of the holder, it is
classified in temporary equity on Z’s balance sheet. Company Z has
elected to apply the accounting policy in ASC 480-10-S99-3A(15)(b) and
is therefore required to recognize changes in the redemption value
immediately as they occur and adjust the carrying amount of the
instrument to equal the redemption value at the end of each reporting
period. Under this method, the end of the reporting period is viewed as
if it were also the redemption date. Thus, in the first financial
reporting period after issuance of the preferred stock, Z adjusts the
carrying amount of the preferred stock to $105 million. As a result, a
“deemed dividend” is recognized in the amount of $10 million, which
reduces the numerator in the calculation of basic EPS in the period of
issuance of the preferred stock.
Two years after
issuance, Z negotiates with the investors to repurchase the preferred
stock at an aggregate redemption price of $102 million. There are no
unpaid accumulated dividends as of the date of repurchase.
The application of ASC 480-10-S99-3A immediately before
the accounting for the redemption has no impact because, according to
the contractual terms of the preferred stock, it is still redeemable for
an aggregate amount equal to $105 million. Since the $102 million fair
value of the consideration transferred is less than the net carrying
amount, Z applies ASC 260-10-S99-2 and recognizes a $3 million credit to
net income in arriving at income available to common stockholders for
the financial reporting period that includes the redemption.
Connecting the Dots
In almost every redemption of preferred stock that is not
being remeasured to its current redemption amount under ASC 480-10-S99-3A, net
income will be adjusted to arrive at income available to common stockholders in
the calculation of basic EPS. Even if the redemption price equals the original
issuance price, the fair value of the consideration transferred will almost
always differ from the net carrying amount of the preferred stock as a result of
direct issuance costs capitalized into the carrying amount of the preferred
stock.
3.2.2.6.3 Induced Conversion of Preferred Stock
When convertible preferred stock is converted into common stock
under an inducement offer, the excess of (1) the fair value of all securities and
other consideration transferred to the holders of the convertible preferred stock over
(2) the fair value of securities issuable according to the original conversion terms
should be deducted from net income to arrive at income available to common
stockholders in the calculation of basic EPS. In effect, an inducement represents the
payment of additional value to convertible preferred security holders for their
agreement to convert the securities. This additional value is always reflected as a
charge to net income in arriving at income available to common stockholders. Unlike
the accounting for a redemption of preferred stock, the accounting for an inducement
of convertible preferred stock can never involve a credit to net income in arriving at
income available to common stockholders.
Induced conversions of convertible debt are discussed in Section 6.6.1. Induced
conversions of common stock that is convertible into another class of common stock are
addressed in Section
3.2.4.1.
Connecting the Dots
In an induced conversion of convertible preferred stock, the
portion of the consideration transferred under the original conversion terms is
always accounted for as a conversion; therefore, ASC 260-10-S99-2 is not
applicable in such circumstances. Rather, ASC 260-10-S99-2 applies only to the
additional value resulting from the inducement offer for the instruments converted
in accordance with this offer.
ASC 260-10-S99-2 does not define an inducement but refers to the
guidance in ASC 470-20, which discusses whether a conversion of convertible debt
represents a conversion under an inducement offer.
ASC 470-20
Recognition of Expense Upon Conversion
40-13 The guidance in
paragraph 470-20-40-16 applies to conversions of convertible debt to
equity securities pursuant to terms that reflect changes made by the
debtor to the conversion privileges provided in the terms of the debt at
issuance (including changes that involve the payment of consideration) for
the purpose of inducing conversion. That guidance applies only to
conversions that both:
-
Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time (inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion)
-
Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted, regardless of the party that initiates the offer or whether the offer relates to all debt holders.
Induced Conversions
40-14 A conversion includes an exchange of a
convertible debt instrument for equity securities or a combination of
equity securities and other consideration, whether or not the exchange
involves legal exercise of the contractual conversion privileges included
in terms of the debt. The preceding paragraph also includes conversions
pursuant to amended or altered conversion privileges on such instruments,
even though they are literally provided in the terms of the debt at
issuance.
40-15 The changed terms may
involve any of the following:
-
A reduction of the original conversion price thereby resulting in the issuance of additional shares of stock
-
An issuance of warrants or other securities not provided for in the original conversion terms
-
A payment of cash or other consideration to those debt holders that convert during the specified time period.
The guidance in [ASC 470-20-40-16] does not apply to
conversions pursuant to other changes in conversion privileges or to
changes in terms of convertible debt instruments that are different from
those described in this paragraph.
An entity should apply the guidance in ASC 470-20 to determine
whether a conversion of convertible preferred stock has occurred in accordance with an
inducement offer. In some cases, the offer may actually represent a modification of
the convertible preferred stock instrument rather than an inducement offer (see
Section 3.2.6 for
discussion of modifications to preferred stock). An inducement offer does not need to
be recognized until the date on which it is accepted by the holder, which is normally
the date on which the holder converts the convertible preferred stock into common
stock or enters into a binding agreement to do so.
The example below illustrates the accounting for an inducement of
convertible preferred stock under ASC 260-10-S99-2.
Example
3-17
Inducement of Convertible Preferred Stock
Company X has issued 1,000 shares of convertible preferred stock to
Company Y at a liquidation preference and original issuance price of
$1,000 per share for total consideration of $1 million. The convertible
preferred stock is not within the scope of ASC 480 and therefore is not
accounted for as a liability by X. The stated conversion terms allow Y to
convert the convertible preferred stock into shares of X’s common stock at
a conversion price of $25. Thus, upon conversion of all the shares of
convertible preferred stock, X would issue Y a total of 40,000 shares of
common stock.
Company X offers Y an inducement to
convert all of the convertible preferred stock into X’s shares of common
stock. Under the offer, Y has 30 days to convert the convertible preferred
stock into X’s shares of common stock at a conversion price of $20 per
share of convertible preferred stock in such a way that Y would receive
50,000 shares of common stock upon conversion of all the shares of
convertible preferred stock. This conversion would (1) occur in accordance
with changed conversion privileges that are exercisable only for a limited
time (i.e., 30 days) and (2) involve the issuance of all the shares of
common stock issuable according to the conversion privileges included in
the terms of the convertible preferred stock at issuance for each share of
convertible preferred stock that Y chooses to convert.
If Y accepts the offer and converts the shares of
convertible preferred stock in return for 50,000 shares of X’s common
stock, the inducement must be accounted for under ASC 260-10-S99-2. If the
offer is accepted and X’s common stock price is $15 on the date of the
induced conversion, the charge that adjusts net income in arriving at X’s
income available to common stockholders is $150,000, calculated as
follows:
The conclusion above would be unchanged if the induced conversion occurred under
the same inducement offer from Y instead of X.
An inducement of convertible preferred stock will result in a charge
to net income in arriving at income available to common stockholders even if the
conversion, after consideration of the inducement offer, is “out-of-the-money.” For
this reason, it is important to distinguish an inducement from a redemption of
convertible preferred stock. If the transaction discussed in the example above
reflected a redemption instead of an induced conversion, there would have been a
$250,000 credit to net income, as opposed to a $150,000 charge to net income, in
arriving at income available to common stockholders.
3.2.2.6.3.1 Induced Conversion of Convertible Preferred Stock That Contains an Embedded Conversion Option Accounted for as a Derivative Liability
ASC 260-10-S99-2 does not address the accounting for an induced
conversion of convertible preferred stock that contains an embedded conversion
option that has been separated and accounted for as a derivative liability. However,
since changes in the fair value of the embedded conversion option are recognized in
net income, the effect of the inducement offer will be reflected in net income as
part of those fair value changes. This obviates the need to recognize any “deemed
dividend” under ASC 260-10-S99-2.
3.2.2.6.3.2 Induced Conversion of Convertible Preferred Stock That Contains a Separately Classified Equity Component
Sections
3.2.5.2.4 and 3.2.5.2.5 address the EPS accounting for an induced conversion of
convertible preferred stock that contains a separately recognized equity component
related to the embedded conversion option. As discussed in those sections, an entity
should first account for the inducement component of the conversion in accordance
with ASC 260-10-S99-2, recognizing a “deemed dividend” for the additional value
provided as a result of the inducement offer. That “deemed dividend” reduces net
income in arriving at income available to common stockholders. Once this accounting
is reflected, the entity accounts for the remaining consideration transferred to the
holder(s) (i.e., the portion represented by the original conversion terms) as a
“conversion” on the basis of the accounting for a conversion of convertible
preferred stock in accordance with its original stated conversion privileges. Also,
as noted in Sections 3.2.5.2.4 and 3.2.5.2.5, the accounting upon an induced conversion will be affected
by the application of ASC 480-10-S99-3A if the convertible preferred stock
instrument is a redeemable equity security that is subject to the
subsequent-measurement guidance in ASC 480-10-S99-3A.
3.2.2.7 Participating Preferred Stock
ASC 260-10-20 defines a participating security as “[a] security that
may participate in undistributed earnings with common stock, whether that participation
is conditioned upon the occurrence of a specified event or not. The form of such
participation does not have to be a dividend — that is, any form of participation in
undistributed earnings would constitute participation by that security, regardless of
whether the payment to the security holder was referred to as a dividend.” When
preferred stock meets the definition of a participating security, income available to
common stockholders will be reduced by both of the following:
- Dividends on cumulative preferred stock, whether or not declared, and dividends declared on noncumulative preferred stock.
- An allocation of the undistributed earnings for the period on the basis of the contractual participation rights of the preferred security. (Losses are generally not allocated to participating preferred stock because such instruments generally only participate in undistributed earnings.)
See Chapter
5 for additional discussion of participating securities and the two-class
method.
3.2.2.8 Reclassification of Preferred Stock to a Liability
ASC
480-10
Mandatorily Redeemable Financial Instruments
25-7 If a financial
instrument will be redeemed only upon the occurrence of a conditional event,
redemption of that instrument is conditional and, therefore, the instrument
does not meet the definition of mandatorily redeemable financial instrument
in this Subtopic. However, that financial instrument would be assessed at
each reporting period to determine whether circumstances have changed such
that the instrument now meets the definition of a mandatorily redeemable
instrument (that is, the event is no longer conditional). If the event has
occurred, the condition is resolved, or the event has become certain to
occur, the financial instrument is reclassified as a liability.
A conditionally redeemable preferred stock instrument may become
mandatorily redeemable as a result of the resolution of a condition associated with the
redemption. In this situation, the preferred stock must be reclassified from equity
(generally, from temporary equity) to a liability. ASC 480-10-30-2 specifies that “[i]f
a conditionally redeemable instrument becomes mandatorily redeemable, upon
reclassification the issuer shall measure that liability initially at fair value and
reduce equity by the amount of that initial measure, recognizing no gain or loss.” While
this type of reclassification has no impact on net income, as discussed in the scope
section of ASC 260-10-S99-2, the reclassification is treated as a redemption of
preferred stock. Thus, any difference between the initial fair value amount of the
liability recognized under ASC 480-10-30-2 and the net carrying amount of the preferred
stock instrument on the reclassification date increases or decreases net income in
arriving at income available to common stockholders. If the preferred stock instrument
is classified in temporary equity and is being remeasured to its redemption amount,
immediately before the reclassification date, which may be a date other than the end
date of a financial reporting period, the net carrying amount of the preferred stock
should be adjusted in a manner consistent with the entity’s accounting policy for
remeasuring redeemable securities under ASC 480-10-S99-3A. See Example 3-9 for an illustration of
this point.
See Section
3.2.6 for information about a reclassification of the preferred stock that
results from a modification of the instrument.
Connecting the Dots
A preferred stock instrument issued by an SEC registrant that
becomes mandatorily redeemable upon the death of the holder is classified as a
liability from the inception of the instrument because the death of the holder is an
event that is certain to occur and SEC registrants are not subject to the scope
exception in ASC 480-10-15-7A. However, a preferred stock instrument that becomes
mandatorily redeemable upon the disability of the holder does not need to be
classified as a liability because the disability of the holder is not an event that
is certain to occur. Such an instrument may also not be classified in temporary
equity if the issuer has the ability and intent to maintain a fully funded insurance
policy (see ASC 480-10-S99-3A(3)(g)). However, upon the disability of the holder,
the preferred stock instrument would need to be reclassified from equity to a
liability and the guidance in ASC 260-10-S99-2 would apply.
3.2.3 Noncontrolling Interests
3.2.3.1 General
The numerator in the calculation of the parent’s basic EPS should
reflect only income from continuing operations and net income attributable to the
parent. In all cases, income attributable to NCIs should be excluded from the numerator
in the parent’s calculation of EPS.
3.2.3.2 Nonredeemable NCIs
An entity may have nonredeemable NCIs that are reported in its
consolidated financial statements. The NCI may be in the form of common stock or
preferred stock issued by a consolidated subsidiary.
3.2.3.2.1 Nonredeemable NCIs in the Form of Preferred Stock
Basic EPS calculated by an entity with a nonredeemable NCI in the
form of preferred stock is affected by dividends accumulated or paid on the preferred
stock by the subsidiary, as well as “deemed dividends” (or “deemed contributions”)
resulting from a modification, redemption, or induced conversion of the preferred
stock by the subsidiary.8 The accounting impact of these events and transactions is generally reflected at
the subsidiary level, with the subsidiary applying the same accounting that a parent
entity would use in such circumstances. Dividends resulting from any of these events
or transactions will be treated as reductions to the subsidiary’s net income in
arriving at the subsidiary’s income available to common stockholders, which will be
included in the numerator of the parent’s calculation of basic EPS. With respect to
redemptions and induced conversions of NCIs in the form of preferred stock, the
guidance in ASC 260-10-S99-2 should be applied to determine the impact on the parent’s
income available to common stockholders in its calculation of basic EPS. In accordance
with ASC 260-10-55-64 through 55-67, these adjustments may reflect an allocation of
the “deemed dividend” (or “deemed contribution”) between the parent’s interest in the
subsidiary’s common stock and any third-party holders of common stock provided that
the third-party noncontrolling common interest holders absorbed or received a portion
of such adjustments.9 See Section 3.2.2.6
for further discussion of redemptions and induced conversions of preferred stock and
Section 3.2.6 for more
information about modifications and exchanges of preferred stock. In addition, see
Section 8.8.1 for
discussion of the application of ASC 260-10-55-64 through 55-67.
Connecting the Dots
When a nonredeemable NCI in the form of preferred stock is
extinguished and the subsidiary has other NCIs in the form of common stock, the
accounting in the consolidated financial statements of the parent may depend on
whether the redemption price was paid by the parent or the subsidiary. Generally
speaking, if the redemption was paid by the parent, the entire difference between
the net carrying amount of the preferred stock and the redemption amount will
increase or reduce net income attributable to the parent in the parent’s
calculation of income available to common stockholders. Otherwise, only the
parent’s allocable portion of the difference between the net carrying amount of
the preferred stock and the redemption amount will increase or reduce net income
attributable to the parent in the parent’s calculation of income available to
common stockholders.
As noted in Example 3-10, an entity may adopt one of two alternative accounting
policies to present dividends on an NCI in the form of preferred stock. The
alternatives affect only the presentation. The impact on income available to common
stockholders will be the same. Under either presentation, dividends accumulated on
cumulative preferred stock and dividends declared on noncumulative preferred stock
will be a reduction to income attributable to the parent in arriving at income
available to common stockholders. If the consolidated subsidiary that has issued the
preferred stock also has outstanding shares of common stock, basic EPS will need to be
calculated at the subsidiary level to determine the amount of the subsidiary’s income
available to common stockholders that is included in the numerator in the parent’s
calculation of basic EPS.
For additional discussion of issues related to dividends on
preferred stock that is issued by a subsidiary to (1) third parties or (2) the parent,
see Section 8.8.2. For
more information about NCIs in the form of preferred stock that represent
participating securities, see Section 3.2.3.4.
3.2.3.2.2 Nonredeemable NCIs in the Form of Common Stock
When an entity has nonredeemable NCIs in the form of common stock,
the entity will need to calculate EPS at the subsidiary level to determine the portion
of the subsidiary’s income available to common stockholders that is included in income
available to common stockholders in the parent’s calculation of basic EPS. See
Section 8.8 for further
discussion of the EPS accounting when a parent has an NCI. See Section 3.2.3.4 for discussion of
NCIs in the form of common stock that participate in earnings of the parent. See
Section 3.2.4.3 for discussion of the
redemption of common stock.
3.2.3.2.3 Multiple Classes of Nonredeemable NCIs in the Form of Common Stock
If a subsidiary has multiple classes of common stock, it is
necessary to calculate basic EPS at the subsidiary level by using the two-class method
to determine the amount of the subsidiary’s income available to common stockholders
that is included in income available to common stockholders in the parent’s
calculation of basic EPS. See Chapter 5 for further discussion of participating securities and the
two-class method. See Section
3.2.3.4 for discussion of NCIs in the form of common stock that
participate in earnings of the parent.
3.2.3.3 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.
- 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.
____________________
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).
An entity may have redeemable NCIs that are reported in its
consolidated financial statements; these interests may be in the form of common stock or
preferred stock. The impact of such NCIs on the parent’s calculation of basic EPS
depends on whether the redeemable NCI is in the form of preferred stock or common stock
and, for common stock, whether the redemption amount is a fair value amount or an amount
other than fair value.
3.2.3.3.1 Redeemable NCIs in the Form of Preferred Stock
ASC 480-10-S99-3A addresses when redeemable preferred stock must be
remeasured to its redemption amount. The requirements in ASC 480-10-S99-3A for
classification and measurement of a redeemable NCI in the form of preferred stock are
consistent with the guidance applicable to redeemable preferred stock issued by a
parent entity (see Section
3.2.2.4). When remeasurement is required, the adjustment to the carrying
amount of the preferred stock is treated in the same manner as a dividend on preferred
stock. There are three primary situations involving redeemable NCIs in the form of
preferred stock:
-
The redemption feature is issued or guaranteed by the parent.
-
The redemption feature is issued by the subsidiary (and not guaranteed by the parent) and all of the subsidiary’s shares of common stock are owned by the parent.
-
The redemption feature is issued by the subsidiary (and not guaranteed by the parent) and the subsidiary also has NCIs in the form of common stock.
If the redemption feature is issued or guaranteed by the parent, the
entire amount of the measurement adjustment (i.e., “deemed dividend”) under ASC
480-10-S99-3A represents an adjustment to income attributable to the parent to arrive
at the parent’s income available to common stockholders. This dividend may generally
be calculated as part of the parent’s calculation of income available to common
stockholders after the inclusion of the parent’s portion of the subsidiary’s income
available to common stockholders in the numerator in the parent’s calculation of basic
EPS.
Connecting the Dots
Redemption features that may be considered issued or guaranteed
by the parent include, but are not limited to, (1) put options issued by a parent
to the holder of preferred shares issued by the parent’s subsidiary if the put
options are considered embedded in the NCI at the consolidated level and (2) put
features that are embedded in preferred shares issued by a subsidiary that are
subject to a guarantee by its parent.
If the redemption feature is issued by the subsidiary (and not
guaranteed by the parent) and there is no other NCI in the subsidiary, the
remeasurement adjustment under ASC 480-10-S99-3A, along with any other dividends on
the preferred stock, will be treated as a reduction of the subsidiary’s net income in
the parent’s calculation of income available to common stockholders. This situation
results in the same impact on the parent’s basic EPS as when the parent issues or
guarantees the redemption feature.
If the redemption feature is issued by the subsidiary (and not
guaranteed by the parent) and parties other than the parent own shares of common stock
in the subsidiary, the remeasurement adjustment under ASC 480-10-S99-3A, along with
other dividends on the subsidiary’s preferred stock, will be treated as a reduction of
the subsidiary’s net income to arrive at the subsidiary’s income available to common
stockholders, which is then used to calculate the parent’s income available to common
stockholders. The amount of dividends and “deemed dividends” that reduce the parent’s
income available to common stockholders will reflect an allocation between the parent
and other common stockholders of the subsidiary. This occurs when the parent includes
its portion of the subsidiary’s income available to common stockholders in the
numerator to calculate the parent’s basic EPS. See further discussion of this process
in Section 8.8.
Example
3-18
Redeemable NCI in the Form of Preferred Stock
Parent A consolidates Subsidiary B under
ASC 810. Parent A has 1 million shares of common stock outstanding and
reported net income of $10 million for the year ended December 31, 20X1
(excluding B’s income). Subsidiary B has 1 million shares of preferred
stock outstanding and 1 million shares of common stock outstanding. For
the year ended December 31, 20X1, B reported net income of $5 million. In
addition, B paid $100,000 of dividends on the preferred stock and
increased the carrying amount of the preferred stock by $200,000 as a
result of a measurement adjustment under ASC 480-10-S99-3A. Consider the
following three scenarios:
- Scenario 1 — A owns all of B’s common stock and guaranteed the redemption feature in B’s preferred stock.
- Scenario 2 — A owns all of B’s common stock and did not guarantee the redemption feature in B’s preferred stock.
- Scenario 3 — A owns 800,000 shares of B’s common stock and did not guarantee the redemption feature in B’s preferred stock.
Parent A would report the following amounts
as the numerator in its calculation of basic EPS:
Scenario 1
Scenario 2
Scenario 3
Connecting the Dots
Under ASC 480-10-S99-3A(16)(e), decreases in the carrying amount
of a subsidiary’s redeemable preferred stock may only be recorded to the extent
that they reflect recoveries of previous increases to the carrying amount as a
result of the application of ASC 480-10-S99-3A.
ASC 260-10-S99-2 applies to the consolidated financial statements of
a parent when there is a redemption or an induced conversion of redeemable preferred
stock issued by a consolidated subsidiary that is classified as an NCI. However,
before accounting for any redemption or induced conversion, an entity must apply the
subsequent-measurement guidance in ASC 480-10-S99-3A. That is, immediately before
accounting for any redemption or induced conversion of a subsidiary’s preferred stock,
the entity should first remeasure the NCI (the subsidiary’s preferred stock) in
accordance with its accounting policy for remeasuring redeemable securities under ASC
480-10-S99-3A if the NCI was subject to remeasurement under ASC 480-10-S99-3A. The
entity should then apply ASC 260-10-S99-2 to account for the redemption or induced
conversion. In applying this guidance, the entity should apply the same concepts as
discussed in ASC 480-10-S99-3A(22)(a) if there is also an NCI in the form of common
stock in the subsidiary. In certain cases, there will be no incremental “deemed
dividend” as a result of the application of ASC 260-10-S99-2 to a redemption of a
subsidiary’s preferred stock because the NCI has been remeasured to the redemption
amount under ASC 480-10-S99-3A. For additional discussion of the complexities
associated with the accounting for redeemable NCIs, see Section 8.8.4.
Redeemable preferred stock issued by a subsidiary may represent a
participating security. See Section
3.2.3.4 for more information.
3.2.3.3.2 Redeemable NCIs in the Form of Common Stock
ASC 480-10-S99-3A addresses when redeemable common stock must be
remeasured to its redemption amount. The requirements in ASC 480-10-S99-3A for
classifying and measuring a redeemable NCI in the form of common stock are consistent
with the guidance applicable to redeemable common stock issued by a parent entity (see
Section 3.2.4.2).
Measurement adjustments under ASC 480-10-S99-3A that are made to the carrying amount
of an NCI in the form of common stock that is redeemable at fair value do not affect
the parent’s EPS. However, when an NCI in the form of common stock is redeemable at
any amount other than fair value, there is an impact on the parent’s EPS. When the
redemption amount is other than fair value, the adjustments to the carrying amount of
the NCI that are recognized under ASC 480-10-S99-3A are accounted for in one of two
ways:
-
As part of the attribution of the subsidiary’s income between the parent and the NCIs.
-
As an adjustment to the amount of income available to common stockholders by applying the two-class method of EPS at the subsidiary level.
Although either of these two approaches is acceptable as an
accounting policy, they generally do not differ in their ultimate impact on the
numerator in the parent’s calculation of basic EPS.
In addition to the alternatives above, there are also two acceptable
alternatives for the treatment of adjustments to the carrying amount under ASC
480-10-S99-3A.
- Treat the entire adjustment in the same manner as a dividend.
- Treat only the portion of the adjustment that reflects a redemption at an amount in excess of fair value in the same manner as a dividend.
In this case, the approach selected will have an impact on the
parent’s calculation of basic EPS.
Under ASC 480-10-S99-3A(16)(e), an entity employing any of the
alternatives discussed above may only record decreases in the carrying amount to the
extent that they reflect recoveries of previous increases to the carrying amount as a
result of the application of ASC 480-10-S99-3A. Furthermore, when an NCI in the form
of common stock is redeemable and the subsidiary also has common stock issued to third
parties that is not redeemable, the parent entity must consider the guidance in ASC
480-10-S99-3A(22)(a). According to that guidance, if the redemption feature in the
redeemable NCI in the form of common stock is either issued or guaranteed by the
parent, the EPS impact of changes to the redemption amount (i.e., “deemed dividends”
under ASC 480-10-S99-3A) should be allocated entirely to the parent.
The example below illustrates the accounting for an NCI in the form
of common stock that is redeemable at a non–fair value amount.
Example
3-19
NCI in the Form of Common Stock Redeemable at Non–Fair Value
Amount
Assume the
following:
- Parent A owns 80 percent of the common stock of Subsidiary B and consolidates B under ASC 810. The remaining 20 percent of B’s common stock is held by a third-party NCI holder.
- The NCI is redeemable at the option of the holder for an amount that does not represent fair value.
- For the reporting period ended December 31, 20X1, before the NCI is remeasured to its redemption amount, the carrying amount of the NCI under ASC 810 is $100,000. This amount reflects an increase of $20,000 as a result of an allocation of 20 percent of B’s net income of $100,000 for the period.
- There is a $50,000 incremental adjustment as of the end of the reporting period to recognize the NCI at its current redemption amount.
- For the reporting period ended December 31, 20X1, A earned net income (excluding B’s net income) of $500,000.
- There were 1 million weighted-average shares of A’s common stock outstanding for the period ended December 31, 20X1.
Parent A applies the recognition and measurement guidance on redeemable equity
securities in ASC 480-10-S99-3A and has elected to treat the entire amount
of remeasurement adjustments related to the NCI as dividends. Below is A’s
consolidated income statement for the reporting period ended December 31,
20X1, depending on whether A elects to (1) treat the remeasurement
adjustments as part of the allocation of income to NCI (Alternative 1) or
(2) apply the two-class method to calculate income available to common
stockholders (Alternative 2).
Connecting the Dots
Although ASC 260-10-S99-2 does not apply to the redemption of an
NCI in the form of common stock, the classification, measurement, and EPS guidance
in ASC 480-10-S99-3A applies if the NCI is redeemable for cash or other assets. If
a redeemable NCI in the form of common stock is being remeasured to its redemption
amount under ASC 480-10-S99-3A, immediately before accounting for any redemption
of the instrument, the entity should perform a final remeasurement of the NCI in
accordance with its accounting policy for remeasuring redeemable securities under
ASC 480-10-S99-3A and should apply the EPS guidance in ASC 480-10-S99-3A to that
remeasurement. The entity should then apply ASC 810 to account for the repurchase
of the NCI.
If an NCI is converted to another security in accordance with an
inducement offer, in addition to applying ASC 480-10-S99-3A if the NCI was a
redeemable security, the entity should consider the accounting impact of the
induced conversion. See Section
3.2.4.1 for further discussion of induced conversions of common
stock.
For additional discussion of the complexities associated with
the accounting for redeemable NCIs, see Section 8.8.4.
3.2.3.4 Participating NCIs
ASC 260-10-20 defines a participating security as “[a] security that
may participate in undistributed earnings with common stock, whether that participation
is conditioned upon the occurrence of a specified event or not. The form of such
participation does not have to be a dividend — that is, any form of participation in
undistributed earnings would constitute participation by that security, regardless of
whether the payment to the security holder was referred to as a dividend.” NCIs that
meet the definition of a participating security generally will fall into one of the
following categories:
-
NCI in the form of common stock that participates in earnings of the parent.
-
NCI in the form of preferred stock that participates in earnings of the subsidiary.
-
NCI in the form of preferred stock that participates in earnings of the parent.
-
NCI in the form of potential common stock that participates in earnings of the subsidiary.
-
NCI in the form of potential common stock that participates in earnings of the parent.
When an NCI in the form of common stock or potential common stock
participates in earnings of the parent, the parent should take the participation into
account by applying the two-class method after including its portion of the subsidiary’s
income available to common stockholders in its calculation of income available to common
stockholders. The effect of the participation should be based on the contractual
participating rights of the NCI holder. For example, if the holder only participates in
earnings of the parent that exclude the net income of the subsidiary, that fact must be
considered in the determination of the amount of the parent’s undistributed earnings
that are allocated between the NCI and the parent’s common stockholders. If the NCI that
participates in earnings of the parent is also a redeemable NCI, the impact that the
redemption provisions have on the calculation of the parent’s basic EPS must be
considered. See Section
8.8.4 for additional discussion of the accounting for redeemable NCIs. See
Chapter 5 for further
details regarding the two-class method of calculating EPS.
An NCI in the form of preferred stock may participate in either the
subsidiary’s or the parent’s earnings. If preferred stock of a subsidiary participates
in the subsidiary’s earnings, an entity needs to calculate basic EPS at the subsidiary
level by using the two-class method to determine the amount of the subsidiary’s income
available to common stockholders that is included in the parent’s income available to
common stockholders. If preferred stock of a subsidiary participates in the parent’s
earnings, the parent should calculate the impact of such participation after including
its portion of the subsidiary’s income available to common stockholders in its
calculation of income available to common stockholders. The effect of the participation
should be based on the contractual participating rights of the NCI holder. For example,
if the holder only participates in earnings of the parent that exclude the net income of
the subsidiary, that fact must be considered in the determination of the amount of the
parent’s undistributed earnings that are allocated between the NCI and the parent’s
common stockholders. If the NCI is also a redeemable NCI, the impact that the redemption
provisions have on the calculation of the parent’s basic EPS must be considered. See
Section 8.8.4 for
additional discussion of the accounting for redeemable NCIs. See Chapter 5 for additional discussion
of the two-class method of calculating EPS.
Section
5.5.2.5.4 addresses NCIs in the form of potential common stock that
participate in earnings of the subsidiary. Section 7.1.3 discusses participating NCIs that are
share-based payment awards.
3.2.3.5 Reclassification of NCIs to a Liability
ASC
480-10
Mandatorily Redeemable Financial Instruments
25-7 If a financial instrument will be redeemed
only upon the occurrence of a conditional event, redemption of that
instrument is conditional and, therefore, the instrument does not meet the
definition of mandatorily redeemable financial instrument in this Subtopic.
However, that financial instrument would be assessed at each reporting
period to determine whether circumstances have changed such that the
instrument now meets the definition of a mandatorily redeemable instrument
(that is, the event is no longer conditional). If the event has occurred,
the condition is resolved, or the event has become certain to occur, the
financial instrument is reclassified as a liability.
A conditionally redeemable NCI may become mandatorily redeemable as a
result of the resolution of a condition associated with redemption. In this situation,
the NCI must be reclassified from equity (generally, from temporary equity) to a
liability. ASC 480-10-30-2 specifies that “[i]f a conditionally redeemable instrument
becomes mandatorily redeemable, upon reclassification the issuer shall measure that
liability initially at fair value and reduce equity by the amount of that initial
measure, recognizing no gain or loss.” While this type of reclassification has no impact
on net income (regardless of whether the form of the NCI is preferred stock or common
stock), immediately before the reclassification date (which may a date other than the
end date of a financial reporting period), the entity should adjust the carrying amount
of the NCI in accordance with its accounting policy for remeasuring redeemable
securities under ASC 480-10-S99-3A if the NCI is being remeasured to its redemption
amount under ASC 480-10-S99-3A.
Section
3.2.6 addresses reclassifications of the NCI that result from modifications
of the instrument.
3.2.3.5.1 NCIs in the Form of Preferred Stock
As discussed in the scope section of ASC 260-10-S99-2, a
reclassification of an NCI in the form of preferred stock from equity to a liability
is treated as a redemption of preferred stock. See Section 3.2.3.2.1 for discussion of the accounting
for a redemption of an NCI in the form of preferred stock.
3.2.3.5.2 NCIs in the Form of Common Stock
A reclassification of an NCI in the form of common stock from equity
to a liability has no impact on basic EPS because ASC 260-10-S99-2 does not apply to
these types of reclassifications.
3.2.4 Common Stock
3.2.4.1 Multiple Classes of Common Stock
An entity that has multiple classes of common stock is subject to the
two-class method of calculating basic EPS. An entity may be deemed to have multiple
classes of common stock solely because one class is redeemable (see Section 3.2.4.2). Both basic and
diluted EPS must be calculated and presented for each class of common stock. See further
discussion of the two-class method in Chapter 5.
If one class of common stock is exchanged or converted into another
class of common stock, the entity should consider whether the transaction represents
either a redemption or a conversion of common stock. Section 3.2.2.6.2.1 discusses considerations related
to distinguishing between a redemption and a conversion. Redemptions of common stock are
further addressed in Section
3.2.4.3.
A class of common stock that is convertible into another class of
common stock could be converted in accordance with an inducement offer. In an induced
conversion from one class of common stock to another, the additional value resulting
from the inducement offer should be accounted for in one of two ways. It should be
treated either as a dividend in the application of the two-class method of calculating
basic EPS or as an expense in a manner consistent with the accounting for reacquisitions
of common stock at a price that exceeds fair value. Section 3.2.4.3 provides guidance on redemptions of
common stock that can be considered in the determination of whether the additional value
resulting from an inducement should be treated as an expense or as a dividend. In making
this determination, an entity may also consider the SEC staff’s views on the treatment
of the additional value transferred in a modification or exchange of preferred stock
that is not accounted for as an extinguishment. See Section 3.2.6 for more information.
If one class of common stock is converted to another class of common
stock in accordance with the stated conversion privileges of the instrument and the
conversion is not considered either a redemption or an induced conversion, the numerator
of basic EPS is unaffected.
3.2.4.2 Redeemable Common Stock
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.FN19
____________________
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.
FN19 Similarly, the two-class method is not
required when share-based payment awards granted to employees are redeemable
at fair value (provided those awards are in the form of common shares or
options on common shares). However, those share-based payment awards may
still be subject to the two-class method pursuant to Section
260-10-45.
An SEC registrant that has outstanding redeemable shares of common
stock is subject to the guidance in ASC 480-10-S99-3A. According to that guidance, if
the common stock is redeemable at the option of the holder or upon the occurrence of any
event outside the issuer’s control, other than an ordinary liquidation, the common stock
must be classified in temporary equity. As discussed in ASC 480-10-S99-3A(14), if the
common stock “is currently redeemable (for example, at the option of the holder), it
should be adjusted to its maximum redemption amount at the balance sheet date.” If the
common stock is not currently redeemable, but it is probable that it will become
redeemable, it must be remeasured to its redemption amount by using one of the following
acceptable methods discussed in ASC 480-10-S99-3A(15):
- Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates.
- Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.
ASC 480-10-S99-3A(21) indicates that the adjustments to the carrying
amount under the two acceptable methods are treated in the same manner as dividends. If
such adjustments pertain to a remeasurement of the carrying amount of common stock that
is redeemable at fair value, changes to the carrying amount of the common stock do not
affect basic EPS. However, if such adjustments are recognized for common stock
redeemable at any amount other than fair value, the entity must apply the two-class
method to calculate basic EPS. Increases to the carrying amount of common stock
redeemable at a non–fair value amount are treated as dividends (or distributions) in the
application of the two-class method. That is, income available to common stockholders
would be reduced by actual cash distributions as well as these “deemed dividends” to
arrive at undistributed earnings. Decreases to the carrying amount of common stock
redeemable at a non–fair value amount, which may only be recognized to the extent the
decreases reflect recoveries of previously recognized increases to the carrying amount
as a result of the application of ASC 480-10-S99-3A, should be treated as “deemed
contributions” when the two-class method is applied. That is, income available to common
stockholders should be reduced by actual cash distributions and increased by these
“deemed contributions” to arrive at undistributed earnings.
In addition, footnote 17 of ASC 480-10-S99-3A provides the following
two acceptable alternative approaches for determining the amount of “deemed dividends”
and “deemed contributions” that pertain to ASC 480-10-S99-3A measurement adjustments to
the carrying amount of common stock redeemable at an amount other than fair value:
- Treat the entire adjustment in the same manner as a dividend.
- Treat only the portion of the adjustment that reflects a redemption at an amount in excess of fair value in the same manner as a dividend.
The approach selected will affect the calculation of basic EPS. The
two examples below illustrate the application of this guidance. For additional details
regarding the application of the SEC’s guidance on redeemable securities, see Chapter 9 of Deloitte’s Roadmap
Distinguishing Liabilities From
Equity.
Example
3-20
Treatment of Common Stock Redeemable at Fair Value in the Calculation of
Basic EPS
Company B issues common stock that contains a redemption provision entitling the
holder of the common stock to put the shares at fair value to B five years
after the issuance of the shares or at any time thereafter (redeemable
common stock). The redeemable common stock represents approximately 20
percent of all outstanding common stock and participates in all the rewards
to which other common shareholders are entitled. It is not considered
permanent equity but is included in temporary equity on B’s balance sheet in
accordance with FRR Section 211 and SEC Regulation S-X, Rule 5-02.27, as
interpreted by ASC 480-10-S99-3A. In accordance with ASC
480-10-S99-3A(15)(b), B has chosen to remeasure the redeemable common stock
to its redemption amount at the end of each reporting period as if that date
was the redemption date.
In B’s calculation of basic EPS, the redeemable common stock should be included
as outstanding common stock (i.e., included in the denominator). The
redeemable common stock is currently outstanding and participates in all the
rewards to which other common shareholders are entitled. Furthermore, since
the redeemable common stock has redemption terms requiring a repurchase
price at fair value, there is no incremental impact on B’s calculation of
basic EPS.
Example
3-21
Impact of Redeemable Common Stock on Basic EPS
Scenario 1
Entity Y has issued common stock with an embedded
redemption (“put”) feature. The put allows the common stockholder to
exchange its common stock for cash equal to the fair value of the common
stock as of the date the put is exercised. The put may be exercised at any
time (i.e., the shares are currently redeemable).
Entity Y has evaluated the common stock and the related put and concluded
the following:
- The put is not a freestanding financial instrument; instead, it is embedded in the common stock. The put does not need to be bifurcated as an embedded derivative under ASC 815-15-25-1 because it qualifies for the scope exception in ASC 815-10-15-74(a) (see also ASC 815-10-15-76).
- The common stock subject to the put is not classified as a liability under ASC 480.
- The puttable common stock is subject to the guidance in ASC 480-10-S99-3A. Accordingly, the shares are classified in temporary equity in Y’s balance sheet. Because they are currently redeemable, the shares are measured at their redemption amount (fair value) as of each balance sheet date.
Entity Y should not adjust income available to
common stockholders for changes in the carrying amount of its puttable
common stock when calculating basic EPS. Because the puttable shares
represent common stock rather than preferred stock and are redeemable at
fair value, changes in their carrying amount do not affect income available
to common stockholders in a manner consistent with ASC 480-10-S99-3A(21). In
addition, Y should not apply the two-class method of calculating basic EPS
as a result of the puttable common stock. ASC 480-10-S99-3A(21) indicates
that since a redemption at fair value does not transfer any value to or from
the holder of the puttable common stock, the two-class method does not
apply.
Although the adjustments to the carrying amount of the puttable common stock
have no impact on Y’s calculations of basic EPS, Y is still subject to the
guidance in ASC 480-10-S99-3A(16)(e), which indicates that “reductions in
the carrying amount of a redeemable equity instrument from the application
of paragraphs 14 and 16 are appropriate only to the extent that the
registrant has previously recorded increases in the carrying amount of the
redeemable equity instrument from the application of paragraphs 14 and
15.”
Scenario 2
Assume the same facts as in Scenario 1 except that the put allows the holders to
redeem the common stock at an amount equal to 10 times the most recent 12
months of Y’s EBITDA. In this circumstance, the redemption price is not
considered fair value or an amount that is designed to approximate fair
value. Footnote 18 of ASC 480-10-S99-3A states, in part, that “[t]he 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.” Thus, because the redemption terms are
not at fair value, Y must consider any increases or decreases in the
carrying amount of the puttable common stock recognized under ASC
480-10-S99-3A in basic EPS by using the two-class method. Those increases
and decreases (limited by the amount of previously recorded increases to the
carrying amount, as discussed in ASC 480-10-S99-3A(16)(e)) should be
considered dividends (or distributed earnings) under the two-class method.
For more information on applying the two-class method, see Chapter 5.
3.2.4.3 Redemption of Common Stock
ASC
505-30
Requirement to Allocate Repurchase Amount
25-3 The facts and circumstances associated with a
share repurchase may suggest that the total payment relates to other than
the shares repurchased. An entity offering to repurchase shares only from a
specific shareholder (or group of shareholders) suggests that the repurchase
may involve more than the purchase of treasury shares. Also, if an entity
repurchases shares at a price that is different from the price obtainable in
transactions in the open market or transactions in which the identity of the
selling shareholder is not important, some portion of the amount being paid
presumably represents a payment for stated or unstated rights or privileges
that shall be given separate accounting recognition. See paragraph
505-30-30-3 for the measurement requirements associated with the different
elements identified within such a transaction.
25-4 Payments by an entity to a shareholder or
former shareholder attributed, for example, to a standstill agreement, or
any agreement in which a shareholder or former shareholder agrees not to
purchase additional shares, shall be expensed as incurred. Such payments do
not give rise to assets of the entity.
Allocating Repurchase Price to Other Elements of the Repurchase
Transaction
30-2 An allocation of
repurchase price to other elements of the repurchase transaction may be
required if an entity purchases treasury shares at a stated price
significantly in excess of the current market price of the shares. An
agreement to repurchase shares from a shareholder may also involve the
receipt or payment of consideration in exchange for stated or unstated
rights or privileges that shall be identified to properly allocate the
repurchase price.
30-3 For example, the selling shareholder may agree
to abandon certain acquisition plans, forego other planned transactions,
settle litigation, settle employment contracts, or restrict voluntarily the
ability to purchase shares of the entity or its affiliates within a stated
time period. If the purchase of treasury shares includes the receipt of
stated or unstated rights, privileges, or agreements in addition to the
capital stock, only the amount representing the fair value of the treasury
shares at the date the major terms of the agreement to purchase the shares
are reached shall be accounted for as the cost of the shares acquired. The
price paid in excess of the amount accounted for as the cost of treasury
shares shall be attributed to the other elements of the transaction and
accounted for according to their substance. If the fair value of those other
elements of the transaction is more clearly evident, for example, because an
entity’s shares are not publicly traded, that amount shall be assigned to
those elements and the difference recorded as the cost of treasury shares.
If no stated or unstated consideration in addition to the capital stock can
be identified, the entire purchase price shall be accounted for as the cost
of treasury shares.
30-4 Transactions do arise, however, in which a
reacquisition of an entity’s stock may take place at prices different from
routine transactions in the open market. For example, to obtain the desired
number of shares in a tender offer to all or most shareholders, the offer
may need to be at a price in excess of the current market price. In
addition, a block of shares representing a controlling interest will
generally trade at a price in excess of market, and a large block of shares
may trade at a price above or below the current market price depending on
whether the buyer or seller initiates the transaction. An entity’s
reacquisition of its shares in those circumstances is solely a treasury
stock transaction properly accounted for at the purchase price of the
treasury shares. Therefore, in the absence of the receipt of stated or
unstated consideration in addition to the capital stock, the entire purchase
price shall be accounted for as the cost of treasury shares.
Allocating the Cost of Treasury Shares to Components of Shareholder
Equity Upon Formal or Constructive Retirement
30-5 An entity that
repurchases its own outstanding common stock may be required under paragraph
505-30-30-3 to allocate a portion of the repurchase price to other elements
of the transaction.
30-6 Once the cost of the treasury shares is
determined under the requirements of this Section, and if a corporation’s
stock is acquired for purposes other than retirement (formal or
constructive), or if ultimate disposition has not yet been decided,
paragraph 505-30-45-1 permits the cost of acquired stock to either be shown
separately as a deduction from the total of capital stock, additional
paid-in capital, and retained earnings, or be accorded the following
accounting treatment appropriate for retired stock.
30-7 The difference between the cost of the
treasury shares and the stated value of a corporation’s common stock
repurchased and retired, or repurchased for constructive retirement, shall
be reflected in capital.
30-8 When a corporation’s stock is retired, or
repurchased for constructive retirement (with or without an intention to
retire the stock formally in accordance with applicable laws), an excess
of repurchase price over par or stated value may be allocated between
additional paid-in capital and retained earnings. Alternatively, the excess
may be charged entirely to retained earnings in recognition of the fact that
a corporation can always capitalize or allocate retained earnings for such
purposes. If a portion of the excess is allocated to additional paid-in
capital, it shall be limited to the sum of both of the following:
- All additional paid-in capital arising from previous retirements and net gains on sales of treasury stock of the same issue
- The pro rata portion of additional paid-in capital, voluntary transfers of retained earnings, capitalization of stock dividends, and so forth, on the same issue. For this purpose, any remaining additional paid-in capital applicable to issues fully retired (formal or constructive) is deemed to be applicable pro rata to shares of common stock.
30-9 When a corporation’s stock is retired, or
repurchased for constructive retirement (with or without an intention to
retire the stock formally in accordance with applicable laws), an excess
of par or stated value over the cost of treasury shares shall be
credited to additional paid-in capital.
30-10 Gains on sales of treasury stock not previously
accounted for as constructively retired shall be credited to additional
paid-in capital; losses may be charged to additional paid-in capital to the
extent that previous net gains from sales or retirements of the same class
of stock are included therein, otherwise to retained earnings.
ASC 505-30 addresses the accounting for repurchases of common stock.
While ASC 260-10-S99-2 does not apply to a reacquisition of common stock, ASC
480-10-S99-3A applies to redeemable common stock. Therefore, the carrying amount of
redeemable common stock on the redemption date should reflect the amount that must be
recognized under ASC 480-10-S99-3A. That is, an adjustment to the carrying amount should
be made in accordance with ASC 480-10-S99-3A immediately before an entity records the
reacquisition of the common stock. The accounting guidance in ASC 505-30 would typically
apply to redeemable common stock only if the reacquisition occurs outside the terms of
the embedded redemption feature in the common stock. In the remaining discussion below,
it is assumed that the reacquisition of common stock occurs in accordance with an
arrangement other than an embedded redemption option in redeemable common stock.
When the price paid to reacquire shares of common stock is fair value,
the repurchase is treated solely as a treasury stock transaction and there is no impact
on income available to common stockholders in the calculation of basic EPS. The
denominator, however, is affected by the decrease in the number of shares of common
stock outstanding. Generally, the reduction in outstanding shares of common stock will
affect the weighted-average number of common shares outstanding only from the repurchase
date.10
ASC 505-30 states that, in some circumstances, the price paid to
repurchase common shares includes other elements, whether stated or unstated, for which
separate accounting is required and provides guidance on allocating the repurchase price
to these other elements. In accordance with ASC 505-30, when an entity pays an amount in
excess of fair value to repurchase its common shares and the excess is attributable to
the receipt of stated or unstated rights, privileges, or agreements in addition to the
treasury stock transaction, those other elements must be accounted for separately from
the treasury stock transaction element. The accounting for the other elements is subject
to the requirements of other GAAP. However, in some circumstances, an entity may
conclude that other GAAP requirements do not address the accounting for the excess of
the repurchase price over fair value and that this excess therefore represents an
expense or a dividend to a common shareholder. In reaching such a conclusion, an entity
must use judgment and evaluate the specific facts and circumstances associated with the
repurchase transaction. If an entity concludes that a payment in excess of fair value is
more characteristic of a dividend than an earnings charge (i.e., because the excess
represents a pro rata distribution), that dividend should reduce net income in arriving
at income available to common stockholders. There could be circumstances in which such a
dividend gives rise to the need to apply the two-class method of calculating basic EPS.
Connecting the Dots
ASC 505-30 discusses two important concepts that an entity must
consider when paying an amount in excess of the current market price to repurchase
shares of common stock.
- Excess of repurchase price per share over the current market price is “insignificant” — ASC 505-30-30-2 indicates that an allocation of the repurchase price to other elements of the transaction may be required if an entity purchases treasury shares at a stated price “significantly in excess of the current market price of the shares.” This means that if an entity has determined that there are no other stated or unstated rights or privileges associated with the share repurchase for which separate accounting is required under other GAAP, and the excess of the repurchase price per share over the current market price per share is not significant, no separate accounting for the excess is required (i.e., the excess is part of the price paid in the treasury stock transaction and does not represent a dividend or expense item). However, even if the repurchase price exceeds the current market price of the common shares by an insignificant amount, an entity must still analyze the repurchase transaction to determine whether there are other elements of the repurchase transaction that should be recognized separately under other GAAP. The treasury stock transaction should not include consideration paid to the selling shareholder that must be accounted for under other GAAP. For this purpose, “significant” is generally interpreted in practice as 10 percent or more.
-
Excess of repurchase price per share over the current market price is “significant” — ASC 505-30-30-4 acknowledges that the excess of the amount paid to repurchase common shares over the current market price may constitute part of the treasury stock transaction even if the repurchase price is significantly “in excess of the current market price“ of the shares. ASC 505-30 focuses on a comparison of the repurchase price per share with the current market price per share; however, this is only the starting point in the analysis. Even if the repurchase price per share exceeds the current market price per share, there are generally no other stated or unstated rights to separately account for if the consideration paid does not exceed the fair value of the shares repurchased. An entity should consider the fair value measurement principles in ASC 820, in particular ASC 820-10-30-2 through 30-3A, in determining whether the repurchase price (i.e., the transaction price) exceeds the fair value of the shares repurchased. A repurchase price per share in excess of the current market price per share may represent an arm’s-length transaction price to just repurchase shares if the consideration paid exceeds the number of shares repurchased times the quoted market price (P × Q) because the shares are thinly traded or the repurchase involves a number of shares that exceed the number the market can readily absorb on a single trading day without significantly affecting the price per share. However, since it is presumed that a significant excess of the amount paid over the current market price represents an element other than a treasury stock transaction, an entity will need sufficient evidence to demonstrate that the repurchase price does not exceed the fair value of the shares repurchased. An entity should consider, among other matters, (1) the relationship it has with the selling shareholder (i.e., whether there is a related-party relationship or another transaction between the entity and the shareholder), (2) the facts and circumstances related to the share repurchase itself, and (3) what it believes to be the fair value of the shares repurchased (i.e., a market price to repurchase the number of shares repurchased). To conclude that the repurchase price represents an arm’s-length transaction when it does not represent P × Q, an entity must be able to determine that the same repurchase price would have been paid to any holder of the shares.11 If an entity cannot conclude that the consideration paid does not exceed the fair value of the shares repurchased, the excess must be associated with something other than the treasury stock transaction. If no other element is identified for which accounting is required under other GAAP, the excess should be treated as a dividend paid to the selling shareholder or as an expense. An entity must use judgment in making this determination and consider the facts and circumstances associated with the excess payment and the relationship between the entity and selling shareholder. When in doubt regarding the treatment of this excess amount, it is generally appropriate for an entity to account for it as an expense.
Example
3-22
Treasury Stock Purchase in Excess of Quoted Market Price
Company T, an entity with publicly traded stock, enters
into a transaction to immediately buy shares of its own common stock at a
price of $8.75 per share, which is approximately 25 percent above the
current quoted market price of $7 per share. The shares to be purchased are
currently held by a single corporation and represent approximately 17
percent of T’s outstanding common shares. Company T states three reasons for
purchasing the shares at an above-market price:
- Although the price is above the quoted market price, it is still an attractive price.
- In one transaction, T can effectively decrease dilution.
- Bidding for that volume of shares in the market, with such small volumes of trade (average daily trade volume is less than 1 percent of T’s total outstanding common shares), will significantly increase the market price even above the contract price.
Provided that the transaction does not involve
the receipt or payment of consideration in exchange for any stated or
unstated rights, privileges, or agreements in addition to the shares of
common stock repurchased, the entire purchase price should be accounted for
as the cost of treasury shares. ASC 505-30-50-3 states the following
regarding how a company should account for treasury shares purchased at a
stated price significantly in excess of the current market price of the
shares:
A repurchase of shares at a price significantly
in excess of the current market price creates a presumption that the
repurchase price includes amounts attributable to items other than the
shares repurchased. A repurchase of shares at a price significantly in
excess of the current market price may require an entity to allocate
amounts to other elements of the transaction under the requirements of
paragraph 505-30-30-2.
If the price paid in
excess of the current market price of the shares represented payment for
consideration received in the transaction other than the shares, the excess
should be attributed to the costs of the other element and accounted for
according to the substance of that element.
The purchase of the shares at a price in excess of the current market price
creates a presumption that the excess price is attributable to items other
than the shares. For the entire purchase price to be accounted for as the
costs of the treasury shares, this presumption needs to be overcome by
sufficient evidence to the contrary. If the presumption cannot be overcome,
the excess price should be attributed to the other items and accounted for
according to the substance of those items. Evidence may include, but is not
limited to, a valuation from an investment banker supporting the price paid
by the company and an analysis of the trading volume indicating that the
company could not purchase this volume of shares in a reasonable amount of
time without significantly affecting the current market price. For example,
T may be able to obtain sufficient evidence to conclude that the price paid
is not influenced by the issuer-holder relationship and that the price would
be the same if T had acquired that number of shares from another holder (or
group of holders).
If there is sufficient evidence to overcome the presumption that the price paid
in excess of the current market price of the shares represents payment for
consideration received in the transaction other than the shares, T should
account for the purchase of the shares in accordance with ASC 505-30-30-4,
which indicates that transactions to repurchase shares of common stock in
excess of the current market price may occur even if the excess is not
attributable to something other than a treasury stock transaction (i.e., the
repurchase price was representative of the fair value of the shares of
common stock repurchased). In other words, if the presumption is overcome,
the entire purchase price should be accounted for as the cost of the
treasury shares. Such accounting would generally be appropriate only if an
entity concludes that the repurchase price represents a price paid in an
arm’s-length transaction for the number of shares repurchased (i.e., a fair
value price for the shares repurchased).
The guidance discussed above also applies to the redemption of an NCI
in the form of common stock (see also Section
7.1.2.2 of Deloitte’s Roadmap Noncontrolling
Interests). If a repurchase of common stock occurs between an entity
and an employee, or with a nonemployee that was a customer or provided goods and
services to the entity, the guidance in ASC 718 should be considered. (For additional
discussion, see Deloitte’s Roadmap Share-Based Payment Awards.) The accounting considerations in
Section 3.2.4.1 are
relevant if an entity extinguishes common stock that was not issued in a share-based
payment arrangement through an induced conversion of one class of common stock to
another.12
3.2.4.3.1 Forward to Repurchase Common Stock and Mandatorily Redeemable Common Stock
ASC 480-10
EPS
45-4 Entities that have issued mandatorily
redeemable shares of common stock or entered into forward contracts that
require physical settlement by repurchase of a fixed number of the
issuer’s equity shares of common stock in exchange for cash shall exclude
the common shares that are to be redeemed or repurchased in calculating
basic and diluted earnings per share (EPS). Any amounts, including
contractual (accumulated) dividends and participation rights in
undistributed earnings, attributable to shares that are to be redeemed or
repurchased that have not been recognized as interest costs in accordance
with paragraph 480-10-35-3 shall be deducted in computing income available
to common shareholders (the numerator of the EPS calculation),
consistently with the two-class method set forth in paragraphs
260-10-45-60 through 45-70.
ASC 480-10-45-4 requires an entity to make the following adjustments
to the calculation of basic EPS for (1) mandatorily redeemable financial instruments
and (2) forward contracts that must be physically settled by repurchase of a fixed
number of shares of common stock in exchange for cash:
-
Numerator (i.e., income available to common stockholders) — The entity uses the two-class method to adjust the numerator for any amounts attributable to such shares that have not been accounted for as interest cost. Under the two-class method, the entity reduces the numerator for the amount of undistributed earnings that are allocable to the shares subject to repurchase.
-
Denominator (i.e., the number of shares outstanding) — In calculating basic and diluted EPS, an entity excludes from the denominator shares of common stock that will be repurchased (i.e., it treats those shares as retired). See further discussion in Section 3.3.3.2.
Paragraph B68 of FASB Statement 150 states:
The
Board decided that the number of outstanding shares associated with physically
settled forward purchase contracts measured at the present value of the contract
amount should be removed from the denominator in computing basic and diluted
earnings per share in the same way as required for mandatorily redeemable shares
classified as liabilities. The Board reasoned that, because the accounting for
physically settled forward contracts reduces equity, even though the shares are
still outstanding, they are effectively accounted for as if retired. Like
mandatorily redeemable shares accounted for as liabilities, shares subject to
physically settled forward contracts should not be treated as outstanding in
earnings per share calculations. The Board noted that amounts paid to holders are
interest costs reflected in earnings available to common shareholders, the numerator
in calculating earnings per share.
Because ASC 480-10-45-3 requires entities to reflect in interest
cost “[a]ny amounts paid or to be paid to holders of [forward repurchase] contracts .
. . in excess of the initial measurement amount,” the numerator is not adjusted for
such amounts under the two-class method. For example, accrued cumulative dividends
should be recognized as interest cost even if they are not declared, as long as the
holder is entitled to such dividends during the life of the contract or at settlement.
Other amounts attributable to the shares under the two-class method, however, might
not have been recognized as interest cost. For example, the holder of a mandatorily
redeemable financial instrument may have a participation right in 10 percent of
dividends paid on common shares if or when they are declared. An amount may therefore
be allocable to the shares subject to repurchase because all earnings for the period
are assumed to have been distributed under the two-class method. However, this amount
may not have been recognized as interest cost under ASC 480 if the holder is not
entitled to it during the life of the contract or at settlement unless the issuer
elects to declare a dividend on common stock.
Example
3-23
Calculating EPS When Shares Are Repurchased in a Forward
Contract
Company A, a public business entity, has 1,000
outstanding common shares. On January 1, A enters into a forward contract
that must be physically settled on December 31 by repurchase of 100 shares
in exchange for a fixed amount of $500. The forward contract does not
provide for any subsequent adjustment of the repurchase price on the basis
of the amount of actual dividends paid. Like other common shares, the 100
shares to be repurchased under the forward contract continue to be
entitled to receive any dividends declared on common shares until the
repurchase date. However, A declares no dividends during the year.
In calculating basic EPS for the year, A excludes the 100
shares that are to be repurchased from the denominator in accordance with
ASC 480-10-45-4. Company A’s earnings for the year are $20,000 (excluding
interest cost accrued on the forward contract under ASC 480-10-35-3). In
the absence of the forward contract, basic EPS for the year would have
been $20 ($20,000 ÷ 1,000).
ASC 480-10-45-4 also requires that A deduct from income available to common
stockholders any amounts (including participation rights in undistributed
earnings) attributable to shares that are to be repurchased. This
requirement is consistent with the two-class method described in ASC 260
(except to the extent that such amounts have already been recognized as
interest cost under ASC 480-10-35-3). Because the forward contract in this
situation does not return to A the actual dividends paid on the 100 shares
to be repurchased, A deducts $2,000 from the EPS numerator to reflect the
participation rights in undistributed earnings attributable to the 100
shares being repurchased, or $20,000 × (100 ÷ 1,000). Accordingly, the EPS
numerator is $18,000 ($20,000 – $2,000). Because the EPS denominator is
900, basic EPS for the period is still $20 ($18,000 ÷ 900).
See Chapter
5 for additional guidance on applying the two-class method.
3.2.4.3.2 Accelerated Share Repurchase Programs
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.
As noted in ASC 505-30-25-5, an accelerated share repurchase program
consists of two separate elements for accounting purposes — a treasury stock
transaction and a forward indexed to the issuer’s own stock. The treasury stock
transaction has no impact on the numerator in the calculation of basic EPS but does
affect the denominator as the shares of common stock are removed from the shares
outstanding from the acquisition date. See Section 8.4 for further discussion of accelerated share repurchase
programs.
3.2.4.3.3 Redemption of Tracking Stock
Some entities have issued classes of stock characterized as
“tracking” or “targeted” stock, which measures the performance of a specific business
unit, activity, or asset of the entity. Shares of tracking stock are traded as
separate securities although they typically are not associated with any specific claim
on the related assets and may grant limited or no voting rights. According to ASC
260-10-45-60B, an entity with tracking stock, which represents a separate class of
stock, must calculate and present EPS for each class of common stock by using the
two-class method.
The terms of tracking stock often allow the issuing entity, at its
option, to exchange or redeem shares of tracking stock for shares of another tracking
stock or the issuer’s main common stock in such a way that the entity would have one
less class of common stock outstanding. The terms of this feature generally require an
entity to pay a premium to the class being redeemed as a result of the transaction.
When the entity pays a premium over fair value to redeem a class of tracking stock,
the premium should be treated as a reduction from net income in arriving at income
available to common stockholders of the class whose shares are being used for the
redemption. The rationale for this treatment is that the holders of the tracking stock
being redeemed have received a benefit that constitutes an additional contractual
return to them. That benefit is absorbed by the class of common stock for which the
entity has issued shares in return for the extinguishment of the class of tracking
stock. The example below illustrates the accounting for a redemption of tracking
stock.
Example
3-24
Treatment of Redemption of Class of Tracking Stock
Company X has two classes of common stock outstanding
that separately track the results of operations of two different
businesses, A and B. Company X decided to redeem all outstanding shares of
its B tracking stock in exchange for shares of its A tracking stock. The
terms of the B stock being redeemed, as disclosed in the Form S-3 filed in
connection with the offering of that security, gave X the right to redeem
the B stock, at its discretion, by issuing shares of its A stock with a
market value equal to a 15 percent premium over the market price of the B
stock at the time of redemption. Therefore, the fair value of A stock to
be exchanged for the B stock will exceed the fair value of the B stock by
15 percent on the date the redemption is announced. The income available
to A stockholders should be reduced by the amount of the 15 percent
premium in the calculation of income available for common stockholders of
A for EPS purposes for the period.
3.2.4.4 Reclassification of Common Stock to a Liability
ASC 480-10
Mandatorily Redeemable Financial Instruments
25-7 If a financial
instrument will be redeemed only upon the occurrence of a conditional event,
redemption of that instrument is conditional and, therefore, the instrument
does not meet the definition of mandatorily redeemable financial instrument
in this Subtopic. However, that financial instrument would be assessed at
each reporting period to determine whether circumstances have changed such
that the instrument now meets the definition of a mandatorily redeemable
instrument (that is, the event is no longer conditional). If the event has
occurred, the condition is resolved, or the event has become certain to
occur, the financial instrument is reclassified as a liability.
A conditionally redeemable common stock instrument may become
mandatorily redeemable as a result of the resolution of a condition associated with
redemption. In this situation, the common stock must be reclassified from equity
(generally, from temporary equity) to a liability. ASC 480-10-30-2 specifies that “[i]f
a conditionally redeemable instrument becomes mandatorily redeemable, upon
reclassification the issuer shall measure that liability initially at fair value and
reduce equity by the amount of that initial measure, recognizing no gain or loss.” This
type of reclassification has no impact on net income and is not within the scope of ASC
260-10-S99-2 because that guidance does not apply to common stock instruments. However,
redeemable common stock is subject to the classification, measurement, and EPS guidance
in ASC 480-10-S99-3A. Therefore, if the common stock is being remeasured to its
redemption amount under ASC 480-10-S99-3A, immediately before the reclassification date
(which may be a date other than the end date of a financial reporting period), the
redeemable common stock instrument should be adjusted to its redemption amount in
accordance with the entity’s accounting policy for remeasuring redeemable securities
under ASC 480-10-S99-3A. If the common stock was not being remeasured to its redemption
amount under ASC 480-10-S99-3A, which may be the case if the redemption was contingent
and its occurrence was not probable, the entity must consider whether the amount payable
under the mandatory redemption feature exceeds the fair value of the common stock. If
so, the entity should consider the guidance on repurchases of common stock at amounts in
excess of fair value (see Section
3.2.4.3).
See Section
3.2.6.2 for more information about situations in which the reclassification
results from a modification of the instrument.
3.2.4.5 Common Stock Issued in Certain R&D Arrangements
See Section
8.10 for discussion of the impact on net income and income available to
common stockholders in certain R&D arrangements.
3.2.4.6 Excise Tax Obligations Related to the Repurchase of Common Stock
Publicly traded companies that repurchase common stock may be
obligated to pay a 1 percent excise tax under IRC Section 4501, which was added by the
Inflation Reduction Act of 2022. This excise tax obligation related to the repurchase of
common stock classified in permanent equity may be accounted for as a cost of the
treasury stock transaction (i.e., recorded in equity). Special considerations apply if
an entity repurchases common stock that is classified in temporary equity or has share
issuance transactions that reduce the total excise tax amount due. See Deloitte’s April
27, 2023, Heads Up
for more information about the accounting for this excise tax.
3.2.5 Other Securities
3.2.5.1 Participating Securities
3.2.5.1.1 Share-Based Payments
ASC
260-10
Participating Securities and the Two-Class Method
45-61 Fully vested share-based compensation
subject to the provisions of Topic 718, including fully vested options and
fully vested stock, that contain a right to receive dividends declared on
the common stock of the issuer, are subject to the guidance in paragraph
260-10-45-60A.
45-61A Unvested share-based payment awards that
contain nonforfeitable rights to dividends or dividend equivalents
(whether paid or unpaid) are participating securities and shall be
included in the computation of EPS pursuant to the two-class method under
the requirements of paragraph 260-10-45-60A.
In accordance with ASC 260-10-45-61 and 45-61A, the following
share-based payment awards represent participating securities to which an entity is
required to apply the two-class method of calculating basic EPS:
- Vested awards — Awards that do not represent outstanding shares of common stock that contain a right to receive dividends declared on the entity’s common stock.
- Unvested awards — Awards that contain a nonforfeitable right to dividends or dividend equivalents.
See Chapter
5 for further details regarding the definition of a participating
security and application of the two-class method and Section 7.1.3 for specific discussion related to
share-based payment awards.
3.2.5.1.2 Other Participating Securities
An entity may have issued freestanding financial instruments, other
than preferred stock and NCIs, that meet the definition of a participating security.
The most common types of instruments that may meet the definition of a participating
security are:
-
Options or warrants to purchase common stock.
-
Forward contracts to purchase or sell common stock.
-
Convertible debt securities.
See Chapter
5 for further discussion of the definition of a participating security
and application of the two-class method.
3.2.5.2 Settlement of Equity-Linked Financial Instruments
An entity may have issued and have outstanding contracts indexed to
its equity (i.e., equity-linked instruments). The security underlying these contracts
may be common stock or preferred stock. The contracts may be classified as assets or
liabilities or in stockholders’ equity. When these contracts are accounted for as assets
or liabilities, any difference between the fair value of the consideration paid or
received upon settlement and the carrying amount is recognized as a gain or loss in
earnings. Thus, the numerator in the calculation of basic EPS is affected through the
gains or losses recognized in net income. The settlement of equity-linked contracts
classified in stockholders’ equity is discussed below.
3.2.5.2.1 Freestanding Equity-Classified Contracts Indexed to an Entity’s Common Stock
ASC 815-40 addresses the settlement of freestanding equity-classified contracts indexed to an issuer’s common stock. ASC 260-10-S99-2 does not apply to the settlement of such contracts. As discussed in footnote 18 of EITF Topic D-98, the application of ASC 260-10-S99-2 “is limited to preferred stock
instruments.”13
The guidance in ASC 815-40 addressing the settlement of contracts
indexed to an entity’s common stock does not specifically address either (1) a
repurchase of an outstanding instrument at an amount that exceeds the fair value of
the instrument on the repurchase date or (2) an inducement offer to exercise the
instrument.
When an entity repurchases an outstanding contract indexed to its
common stock, the repurchase price is generally equal to the fair value of the
contract. However, if an entity pays an amount in excess of fair value, the excess
should be accounted for in the same manner as a repurchase of common stock at an
amount in excess of the current market price, as discussed in Section 3.2.4.3. Thus, if the
consideration transferred upon settlement exceeds the fair value of the equity-linked
instrument on the settlement date, the excess consideration may need to be recognized
as a dividend or an expense. Any such amount recognized as a dividend will reduce
income available to common stockholders in a manner similar to the application of the
two-class method.
If an entity settles a contract indexed to its common stock under an
inducement offer, the additional value provided as a result of the inducement offer,
which is calculated as the fair value of all securities and other consideration
transferred in the transaction over the fair value of the capital stock issuable
according to the original terms of the contract, should be treated as a dividend or an
expense. Any such amount recognized as a dividend will reduce income available to
common stockholders in a manner similar to the application of the two-class method.
Section 3.2.4.3
provides additional discussion of the treatment of such an amount as a dividend or an
expense.
See Section
3.2.5.3 for discussion of the treatment of down-round features in
freestanding equity-linked contracts that are classified in stockholders’ equity.
3.2.5.2.2 Freestanding Equity-Classified Contracts Indexed to an Entity’s Preferred Stock
The settlement of an equity-classified freestanding contract that is
indexed to an entity’s preferred stock is accounted for in the same way as a
settlement of convertible preferred stock that does not contain a separately
recognized equity component (see Sections 3.2.2.5.4, 3.2.2.6.2.1, and 3.2.2.6.3). A summary of the accounting, which depends on the nature of
the settlement, is as follows:
-
Exercise — A settlement of an equity-classified freestanding contract indexed to an entity’s preferred stock that occurs on the basis of an exercise of the instrument according to its stated terms is not accounted for under ASC 260-10-S99-2 and has no impact on the numerator in the entity’s calculation of basic EPS.
-
Redemption — ASC 260-10-S99-2 applies to the redemption of an equity-classified freestanding contract indexed to an entity’s preferred stock regardless of the form of the consideration provided on redemption. Therefore, any difference between the total fair value of the consideration transferred to redeem the instrument and the net carrying amount of the instrument should be treated as an adjustment to net income in arriving at income available to common stockholders.
-
Inducement — In an inducement, the excess of (1) the fair value of all securities and other consideration transferred in the transaction to the holders of the equity-linked contract over (2) the fair value of securities issuable in accordance with the original exercise terms should be deducted from net income to arrive at income available to common stockholders in the calculation of basic EPS. Once this additional value is recognized, the entity applies the accounting applicable to an exercise of an equity-classified freestanding contract indexed to an entity’s preferred stock. Accordingly, in such situations, there is no additional impact on the numerator in the calculation of basic EPS.
3.2.5.2.3 Convertible Debt That Contains a Separately Classified Equity Component Indexed to an Entity’s Common Stock
ASC 480-10 — SEC
Materials — SEC Staff Guidance
SEC Staff
Announcement: Classification and Measurement of Redeemable
Securities
S99-3A(3)(e)
Convertible debt instruments that contain a separately classified
equity component. Other applicable GAAP may require a convertible
debt instrument to be separated into a liability component and an equity
component.FN8 In these situations, the equity-classified
component of the convertible debt instrument should be considered
redeemable if at the balance sheet date the issuer can be required to
settle the convertible debt instrument for cash or other assets (that is,
the instrument is currently redeemable or convertible for cash or other
assets). For these instruments, an assessment of whether the convertible
debt instrument will become redeemable or convertible for cash or other
assets at a future date should not be made. For example, a convertible
debt instrument that is not redeemable at the balance sheet date but could
become redeemable by the holder of the instrument in the future based on
the passage of time or upon the occurrence of a contingent event is not
considered currently redeemable at the balance sheet date.
S99-3A(12)(d) For convertible debt instruments
that contain a separately classified equity component, an amount should
initially be presented in temporary equity only if the instrument is
currently redeemable or convertible at the issuance date for cash or other
assets (see paragraph 3(e)). The portion of the equity-classified
component that is presented in temporary equity (if any) is measured as
the excess of (1) the amount of cash or other assets that would be
required to be paid to the holder upon a redemption or conversion at the
issuance date over (2) the carrying amount of the liability-classified
component of the convertible debt instrument at the issuance
date.
S99-3A(16)(d) For convertible debt instruments
that contain a separately classified equity component, an amount should be
presented in temporary equity only if the instrument is currently
redeemable or convertible at the balance sheet date for cash or other
assets (see paragraph 3(e)). The portion of the equity-classified
component that is presented in temporary equity (if any) is measured as
the excess of (1) the amount of cash or other assets that would be
required to be paid to the holder upon a redemption or conversion at the
balance sheet date over (2) the carrying amount of the
liability-classified component of the convertible debt instrument at the
balance sheet date.FN15
S99-3A(23)
Convertible debt instruments that contain a separately classified
equity component. For convertible debt instruments subject to ASR
268 (see paragraph 3(e)), there should be no incremental earnings per
share accounting from the application of this SEC staff announcement.
Subtopic 260-10 addresses the earnings per share accounting.
____________________
FN8 See Subtopics 470-20 and 470-50; and
Paragraph 815-15-35-4.
FN15 ASR 268 does
not impact the application of other applicable GAAP to the accounting for
the liability component or the accounting upon derecognition of the
liability and/or equity component.
A convertible debt instrument will contain a separately recognized
component in common stockholders’ equity if the convertible debt:
- Has been modified in a transaction that increased the fair value of the embedded conversion option but did not result in an extinguishment (see ASC 470-50-40-15).
- Contains an embedded conversion option that has been reclassified from a derivative liability to equity (see ASC 815-15-35-4).
- Was issued at a substantial premium (see ASC 470-20-25-13).
The Codification addresses the accounting for a settlement of a
convertible debt instrument that contains a separately recognized component in common stockholders’ equity. While the classification and measurement provisions of ASC 480-10-S99-3A apply to convertible debt that contains a separately recognized component classified in common stockholders’ equity, the EPS guidance in ASC 480-10-S99-3A does not apply in such circumstances. Furthermore, ASC 260-10-S99-2 also does not apply to any settlement of a convertible debt instrument that contains a separately recognized component in common stockholders’ equity. This observation is consistent with footnote 18 of EITF Topic D-98, which states:
Topic D-42 also does not apply to convertible debt instruments that contain an
embedded conversion option indexed to the issuer’s common stock because the
application of Topic D-42 is limited to preferred stock instruments.
While this footnote was not codified, it continues to reflect the
SEC staff’s view. Therefore, neither the EPS guidance in ASC 480-10-S99-3A nor the EPS
guidance in ASC 260-10-S99-2 applies to any settlement of a convertible debt
instrument that contains a separately recognized component in common stockholders’
equity. Rather, only the settlement guidance in other areas of the Codification should
be applied (see Sections
6.2.2 and 6.3.2 for additional discussion). This view is premised on the SEC
staff’s view that because ASC 260-10-S99-2 applies only to preferred stock
instruments, it does not apply to equity-classified components that are indexed to an
entity’s common stock.
Connecting the Dots
The view expressed above would also apply to a convertible instrument issued in
the legal form of preferred stock that is classified as a liability under ASC
480-10-25-4 (i.e., a convertible preferred stock instrument for which the
principal amount must be paid in cash and that gives the issuer the option of
paying any excess conversion value in cash or stock).
3.2.5.2.4 Convertible Preferred Stock That Contains a Separated Equity Component Indexed to an Entity’s Common Stock
An entity may have outstanding convertible preferred stock
(classified in temporary equity or permanent equity) containing a separated equity component recognized in common stockholders’ equity. As noted in the previous section, ASC 480-10-S99-3A(23) provides special EPS guidance on convertible debt that contains a separate equity component recognized in common stockholders’ equity. Footnote 17 of EITF Topic D-98 states the following regarding applying this special guidance by
analogy:
The guidance provided in this paragraph for convertible
debt instruments that contain an equity-classified component should not be applied
by analogy to other equity instruments that are subject to ASR 268 and this SEC
staff announcement.
We think that the SEC staff included the reference to “convertible debt instruments” in this footnote because it believed that EITF Topic D-42 (i.e., ASC
260-10-S99-2) does apply to certain types of settlements of a host preferred stock instrument when the convertible preferred stock contains a separate component recognized in common stockholders’ equity. However, we do not think that the staff believed that the settlement of the equity-classified component indexed to the entity’s common stock is within the scope of ASC 260-10-S99-2 because of its view, as originally expressed in footnote 18 of EITF Topic D-98, that only preferred stock instruments are within the scope of EITF Topic D-42. The table below describes the
accounting guidance that applies to convertible preferred stock containing a
separately recognized component classified in common stockholders’ equity. The
following assumptions apply to the matters discussed in this table:
-
The embedded conversion option is indexed to the issuer’s common stock.
-
The embedded conversion option is not accounted for as a derivative liability.
-
The convertible preferred stock instrument is not classified as a liability.
The table does not comprehensively discuss the application of ASC
480-10-S99-3A, which may affect the accounting.
Table
3-7
Nature of
Separately Recognized Equity Component | Accounting for
Settlement |
---|---|
Modified embedded conversion option | As discussed in
Section
3.2.6.1.1, an entity should generally account for a
modification or exchange that affects the embedded conversion option in a
convertible preferred stock instrument, and that does not result in an
extinguishment, by recognizing any incremental fair value provided to the
preferred stockholder(s) as a “deemed dividend” or an expense. However,
given the lack of specificity in the accounting literature, an entity may
determine that it is appropriate to recognize — as a separate component of
common stockholders’ equity by analogy to ASC 470-50-40-15 — an increase
in the fair value of the embedded conversion option arising from a
modification or exchange affecting the embedded conversion option in a
convertible preferred stock instrument. The
accounting for a settlement of a convertible preferred stock instrument
containing a separately recognized component in common stockholders’
equity that resulted from a modification or exchange that affected the
embedded conversion option in a convertible preferred stock instrument
depends on the nature of the settlement as follows:
ASC 480-10-S99-3A applies to redeemable convertible preferred stock containing a
separately recognized component in common stockholders’ equity that
resulted from a modification or exchange that affected the embedded
conversion option in a convertible preferred stock instrument. The
classification of that separate equity component within equity (i.e., as
temporary equity or permanent equity) when convertible preferred stock is
a redeemable equity security is subject to an accounting policy election
for which two views are acceptable:
Regardless of which view is applied, if the convertible preferred stock
is being remeasured to its redemption amount in accordance with the
subsequent-measurement guidance in ASC 480-10-S99-3A, the entity should
follow its remeasurement policy under ASC 480-10-S99-3A and recognize the
effects of such remeasurement, including the impact on EPS, immediately
before accounting for any settlement. This “final” measurement adjustment
may affect the carrying amount of the convertible preferred stock and thus
the settlement accounting applied to the three settlement types discussed
above. |
Reclassified embedded conversion option (note that if the
reclassification occurs as a result of a modification or exchange, the
guidance in Section
3.2.6 applies) | ASC 815-15-35-4,
which addresses the accounting for a reclassification of an embedded
conversion option in a debt instrument from a liability to equity,
states: If an embedded conversion option in a
convertible debt instrument no longer meets the bifurcation criteria in
this Subtopic, an issuer shall account for the previously bifurcated
conversion option by reclassifying the carrying amount of the liability
for the conversion option (that is, its fair value on the date of
reclassification) to shareholders’ equity. Any debt discount recognized
when the conversion option was bifurcated from the convertible debt
instrument shall continue to be amortized. This approach should be applied when an embedded conversion option
indexed to the entity’s common stock in a preferred stock instrument is
reclassified from a derivative liability to equity. Therefore, the fair
value of the embedded conversion option liability should be reclassified
to stockholders’ equity and reported as a separate component of common
stockholders’ equity. The fair value of the embedded conversion option
liability should be adjusted, with any change recognized in earnings,
immediately before the reclassification so that the reclassified amount
reflects the fair value of the embedded conversion option on the
reclassification date. The accounting for a
settlement of a convertible preferred stock instrument that contains a
separately recognized component in common stockholders’ equity that
resulted from a reclassification of the embedded conversion option from a
liability to equity depends on the nature of the settlement as follows:
ASC 480-10-S99-3A applies to redeemable convertible preferred stock containing a
separately recognized component in common stockholders’ equity that
resulted from a reclassification of the embedded conversion option from a
liability to equity. The classification of that separate equity component
within equity (i.e., as temporary equity or permanent equity) when
convertible preferred stock is a redeemable equity security is subject to
an accounting policy election consistent with the two views discussed
above under “modified embedded conversion option.” Regardless of which
view is applied, if the convertible preferred stock is being remeasured to
its redemption amount in accordance with the subsequent-measurement
guidance in ASC 480-10-S99-3A, the entity should follow its remeasurement
policy under ASC 480-10-S99-3A and recognize the effects of such
remeasurement, including the impact on EPS, immediately before accounting
for any settlement. This “final” measurement adjustment may affect the
carrying amount of the convertible preferred stock and thus the settlement
accounting applied to the three settlement types discussed above. |
Down-round feature has been triggered
|
As discussed in Section 3.2.2.5.1, an entity may
recognize a dividend and an increase in APIC (i.e., common stockholders’
equity) as a result of a down-round feature that has been triggered in a
convertible preferred stock instrument.
The Codification does not specifically address the
accounting for a settlement of a convertible preferred stock instrument
containing a separately recognized component in common stockholders’
equity that resulted from the recognition of a down-round feature that has
been triggered. However, the following accounting would be acceptable
under GAAP:
ASC 480-10-S99-3A applies to redeemable convertible
preferred stock containing a separately recognized component in common
stockholders’ equity that resulted from a down-round feature that had been
previously triggered. On the basis of discussions with the staff in the
SEC’s Office of the Chief Accountant (OCA), we understand that the SEC
staff will object if an entity classifies the credit entry as APIC within
temporary equity. Therefore, if the convertible preferred stock is subject
to remeasurement under ASC 480-10-S99-3A, any remeasurement adjustments
must be made without regard to the amount recognized in APIC (permanent
equity) when the down-round feature was triggered. The SEC staff indicated
that SEC registrants must apply this view even though such application may
result in “double-counting” the effect on EPS for a convertible preferred
share that is being remeasured to its redemption amount for which a
down-round feature has been triggered. In addition, we have confirmed with
the OCA staff that this view applies only to convertible preferred stock
arrangements that are subject to the down-round guidance in ASC 260 -10.
Therefore, we believe that it is still acceptable to apply either of the
two alternative views discussed above on the classification of the
separately recognized equity component in a redeemable convertible
preferred share that contains a modified embedded conversion option or an
equity component from reclassification of the conversion option.
If the convertible preferred stock is being remeasured to its redemption
amount in accordance with the subsequent-measurement guidance in ASC
480-10-S99-3A, the entity should follow its remeasurement policy under ASC
480-10-S99-3A and recognize the effects of such remeasurement, including
the impact on EPS, immediately before accounting for any settlement. This
“final” measurement adjustment may affect the carrying amount of the
convertible preferred stock and thus the settlement accounting applied to
the three settlement types discussed above.
|
3.2.5.2.5 Convertible Preferred Stock That Contains a Separated Equity Component Indexed to the Entity’s Preferred Stock
It is unusual to encounter a convertible preferred stock instrument
with an embedded conversion option that is indexed to a different class of preferred
stock and a separately recognized equity-classified component. However, this situation
could exist if an entity reclassified an embedded conversion option indexed to a class
of preferred stock from a liability to equity after this feature was bifurcated from a
host preferred stock instrument. If this situation does exist, the separately
classified equity component must be classified outside of common stockholders’ equity
since the embedded conversion option is indexed to the issuer’s preferred stock. The
accounting for a settlement of such an instrument depends on the nature of the
settlement as follows:
-
Conversion — In accounting for a conversion, an entity should use the conversion accounting approach specified in Table 3-7. That is, any remaining discount on the convertible preferred stock should be immediately amortized and treated as a “deemed dividend” that reduces net income in arriving at income available to common stockholders.
-
Redemption — In a redemption, ASC 260-10-S99-2 applies to both the convertible preferred stock instrument and the separated equity component. Thus, the difference between the fair value of the total consideration transferred to redeem the convertible preferred stock over the aggregate carrying amounts of the convertible preferred stock and separately recognized equity component should be treated as a “deemed dividend” (or “deemed contribution”) that results in an adjustment to net income in arriving at income available to common stockholders.
-
Induced conversion — An induced conversion should be accounted for in a manner consistent with the approach specified in Table 3-7. That is, an entity should employ a two-step approach under which it first applies ASC 260-10-S99-2 to capture the additional value provided by the inducement offer and then applies the accounting specified for a conversion in accordance with the stated conversion privileges.
In line with the discussion in Table 3-7, ASC 480-10-S99-3A applies to
convertible preferred stock that contains a separately recognized equity component
indexed to an entity’s preferred stock. This separate equity component would generally
be classified in temporary equity if the convertible preferred stock is a redeemable
equity security subject to ASC 480-10-S99-3A. If the convertible preferred stock is
being remeasured to its redemption amount in accordance with the
subsequent-measurement guidance in ASC 480-10-S99-3A, the entity should follow its
remeasurement policy under ASC 480-10-S99-3A and recognize the effects of such
remeasurement, including the impact on EPS, before applying settlement accounting.
3.2.5.3 Down-Round Features in Freestanding Financial Instruments
ASC
260-10
05-1A An entity may issue a
freestanding financial instrument (for example, a warrant) with a down round
feature that is classified in equity. This Subtopic provides guidance on
earnings per share and recognition and measurement of the effect of a down
round feature when it is triggered.
Financial Instruments That Include a
Down Round Feature
25-1 An entity that presents earnings per share
(EPS) in accordance with this Topic shall recognize the value of the effect
of a down round feature in an equity-classified freestanding financial
instrument and an equity-classified convertible preferred stock (if the
conversion feature has not been bifurcated in accordance with other
guidance) when the down round feature is triggered. That effect shall be
treated as a dividend and as a reduction of income available to common
stockholders in basic earnings per share, in accordance with the guidance in
paragraph 260-10-45-12B. See paragraphs 260-10-55-95 through 55-97 for an
illustration of this guidance.
Financial Instruments That Include a
Down Round Feature
30-1 As of the date that a
down round feature is triggered (that is, upon the occurrence of the
triggering event that results in a reduction of the strike price) in an
equity-classified freestanding financial instrument and an equity-classified
convertible preferred stock (if the conversion feature has not been
bifurcated in accordance with other guidance), an entity shall measure the
value of the effect of the feature as the difference between the following
amounts determined immediately after the down round feature is triggered:
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.
30-2 The fair values of the
financial instruments in paragraph 260-10-30-1 shall be measured in
accordance with the guidance in Topic 820 on fair value measurement. See
paragraph 260-10-45-12B for related earnings per share guidance and
paragraphs 505-10-50-3 through 50-3A for related disclosure guidance.
Financial Instruments That Include a
Down Round Feature
35-1 An entity shall
recognize the value of the effect of a down round feature in an
equity-classified freestanding financial instrument and an equity-classified
convertible preferred stock (if the conversion feature has not been
bifurcated in accordance with other guidance) each time it is triggered but
shall not otherwise subsequently remeasure the value of a down round feature
that it has recognized and measured in accordance with paragraphs
260-10-25-1 and 260-10-30-1 through 30-2. An entity shall not subsequently
amortize the amount in additional paid-in capital arising from recognizing
the value of the effect of the down round feature.
Freestanding Equity-Classified
Financial Instrument With a Down Round Feature
45-12B For a freestanding
equity-classified financial instrument and an equity-classified convertible
preferred stock (if the conversion feature has not been bifurcated in
accordance with other guidance) with a down round feature, an entity shall
deduct the value of the effect of a down round feature (as recognized in
accordance with paragraph 260-10-25-1 and measured in accordance with
paragraphs 260-10-30-1 through 30-2) in computing income available to common
stockholders when that feature has been triggered (that is, upon the
occurrence of the triggering event that results in a reduction of the strike
price).
Example 16: Equity-Classified
Freestanding Financial Instruments That Include a Down Round
Feature
55-95 Assume Entity A issues
warrants that permit the holder to buy 100 shares of its common stock for
$10 per share and that Entity A presents EPS in accordance with the guidance
in this Topic. The warrants have a 10-year term, are exercisable at any
time, and contain a down round feature. The warrants are classified as
equity by Entity A because they are indexed to the entity’s own stock and
meet the additional conditions necessary for equity classification in
accordance with the guidance in Subtopic 815-40 on derivatives and hedging —
contracts in entity’s own equity (see paragraphs 815-40-55-33 through 55-34A
for an illustration of the guidance in Subtopic 815-40 applied to a warrant
with a down round feature). Because the warrants are an equity-classified
freestanding financial instrument, they are within the scope of the
recognition and measurement guidance in this Topic. The terms of the down
round feature specify that if Entity A issues additional shares of its
common stock for an amount less than $10 per share or issues an
equity-classified financial instrument with a strike price below $10 per
share, the strike price of the warrants would be reduced to the most recent
issuance price or strike price, but the terms of the down round feature are
such that the strike price cannot be reduced below $8 per share. After
issuing the warrants, Entity A issues shares of its common stock at $7 per
share. Because of the subsequent round of financing occurring at a share
price below the strike price of the warrants, the down round feature in the
warrants is triggered and the strike price of the warrants is reduced to $8
per share.
55-96 In accordance with the
measurement guidance in paragraphs 260-10-30-1 through 30-2, Entity A
determines that the fair value of the warrants (without the down round
feature) with a strike price of $10 per share immediately after the down
round feature is triggered is $600 and that the fair value of the warrants
(without the down round feature) with a strike price of $8 per share
immediately after the down round feature is triggered is $750. The increase
in the value of $150 is the value of the effect of the triggering of the
down round feature.
55-97 The $150 increase is
the value of the effect of the down round feature to be recognized in equity
in accordance with paragraph 260-10-25-1, as follows:
Additionally, Entity A reduces income available to common
stockholders in its basic EPS calculation by $150 in accordance with the
guidance in paragraph 260-10-45-12B. Entity A applies the treasury stock
method in accordance with paragraphs 260-10-45-23 through 45-27 to calculate
diluted EPS. Accordingly, the $150 is added back to income available to
common stockholders when calculating diluted EPS. However, the treasury
stock method would not be applied if the effect were to be antidilutive.
For equity-classified freestanding financial instruments that contain
a down-round feature (including equity-classified convertible preferred stock, as
discussed in Section
3.2.2.5.1), an adjustment to income available to common stockholders is
required when the down-round feature is triggered. That adjustment is calculated in
accordance with ASC 260-10-30-1. No such adjustment is required when a down-round
feature in a convertible debt instrument is triggered.
For equity-linked freestanding financial instruments that are classified as a liability
(e.g., the instrument does not meet the indexation conditions in ASC 815-40 for reasons
other than the down-round feature), the EPS adjustment discussed in ASC 260-10-30-1, as
well as the related recognition in equity of the effect of the triggered down-round
feature, is not required. Rather, the mark-to-market adjustment that must be recognized
in earnings for such liability-classified instruments will reflect the impact of the
down-round feature.
3.2.6 Modifications and Exchanges of Equity Instruments
3.2.6.1 Modification or Exchange of Preferred Stock
Modifications or exchanges of preferred stock instruments must be
evaluated to determine whether the changes reflect an extinguishment of preferred stock
that must be accounted for under ASC 260-10-S99-2. The Codification does not
specifically address how to perform this evaluation. However, in his remarks
before the 2014 AICPA Conference on Current SEC and PCAOB Developments, Kirk Crews, then
a professional accounting fellow in the SEC’s Office of the Chief Accountant, noted that
registrants may use one of the following approaches in determining whether an amendment
to, or exchange of, an equity-classified preferred stock instrument constitutes a
modification or extinguishment:
- Qualitative approach — An entity would consider the significance of additions, removals, and changes to existing contractual terms. In addition, the entity would “evaluate the business purpose for the changes and how the changes may influence the economic decisions of the investor.” If the entity determines that the changes are significant, it would treat the amendments or exchange as an extinguishment; otherwise, it would treat the changes as a modification to the preferred stock.
- Fair value approach — An entity would compare the fair value of the preferred stock after the amendment or exchange with the fair value of the preferred stock immediately before the amendment or exchange to determine whether the preferred stock is substantially different. If there is a 10 percent or greater change in the fair value of the preferred stock, the entity would consider the preferred stock to be substantially different and account for the amendment or exchange as an extinguishment. If, however, the change is less than 10 percent, a preferred stock modification has occurred.
- Cash flow approach — An entity would compare the contractual cash flows of the preferred stock after the amendment or exchange with the contractual cash flows of the preferred stock immediately before the amendment or exchange to determine whether the preferred stock is substantially different. As it would under the fair value approach, the entity would consider a change of 10 percent or greater to be substantially different and would account for the amendment or exchange as an extinguishment. A change of less than 10 percent would be considered a modification. See ASC 470-50-40 for guidance on how to perform the 10 percent cash flow test.
Mr. Crews indicated that the qualitative approach is the “most common
approach” observed by the SEC staff.
Connecting the Dots
The cash flow approach is not appropriate unless the preferred
stock contains a redemption feature. Without a redemption feature, there are no
contractual cash flows to evaluate in a preferred stock instrument.
In addition, Mr. Crews noted that some registrants may be using the
legal form approach to determine whether an amendment to, or exchange of, an
equity-classified preferred stock constitutes a modification or an extinguishment. Under
the legal form approach, an exchange that results in the issuance of new preferred stock
would be accounted for as an extinguishment of the exchanged preferred stock. Mr. Crews
cautioned registrants that the legal form is merely one factor in the evaluation of
whether an amendment or exchange should be accounted for as a modification or an
extinguishment and emphasized that the form of the change in and of itself should not be
determinative of the accounting outcome.
Connecting the Dots
The three approaches described above are generally not applied to
a modification or exchange of preferred stock that is akin to a troubled debt
restructuring, since such a modification or exchange is generally not treated as an
extinguishment.
Mr. Crews suggested that if a registrant determines that an amendment
to, or exchange of, equity-classified preferred stock is a modification, it would be
appropriate for the entity to analogize to the modification guidance in ASC 718-20 on
modifications to equity-classified share-based payment awards. If the fair value of the
instrument after the modification exceeds its fair value before the modification, the
entity should recognize the incremental fair value to reflect the modification. Mr.
Crews indicated that the SEC staff would not object to an entity’s recognition of the
additional fair value in retained earnings as a deemed dividend from the entity to the
preferred stockholders. (This means that in calculating EPS, an entity would deduct the
incremental fair value from net income in determining income available to common
stockholders.) Mr. Crews suggested that in certain unique circumstances, it may be
appropriate to recognize the additional fair value as an expense (e.g., if facts and
circumstances indicate that it reflects compensation for agreeing to restructure the
preferred stock). He noted that the appropriate method for recognizing the additional
fair value would depend on “the underlying purpose for and circumstances surrounding the
modification.”
Connecting the Dots
The incremental fair value in a modification or exchange of
preferred stock that is not considered an extinguishment is generally treated either
as a “deemed dividend” that reduces net income in arriving at income available to
common stockholders or as an expense that reduces income available to common
stockholders through a reduction of net income. Although uncommon, there may be
circumstances in which a modification or exchange of preferred stock reflects a
transaction that only affects preferred stockholders. If an entity can conclude that
a modification or exchange solely reflects a reallocation of shareholder value
between preferred shareholder groups, it may be appropriate not to reflect the
incremental value provided to one preferred shareholder group since the incremental
loss to the corresponding preferred shareholder group is also not recognized.
However, if there is any impact on common shareholders, an entity must apply
the guidance discussed by the SEC staff to reflect the impact of the incremental
fair value provided to preferred stockholders as a result of the modification or
exchange of preferred stock.
It is not appropriate to account for a transfer of wealth from a
preferred stock investor to common shareholders as an increase to net income in
arriving at income available to common stockholders. That is, only increases in fair
value of preferred stock instruments are recognized in a modification or exchange of
preferred stock (i.e., reductions in fair value are not recognized).
Mr. Crews did not discuss the accounting for fees and costs paid to
investors in a modification or exchange of preferred stock that is not treated as an
extinguishment. However, these fees and costs should be recognized as charges to
retained earnings or net income in a manner consistent with the recognition of the
incremental fair value resulting from the modification or exchange. Accordingly, such
fees and costs will also reduce income available to common stockholders.
Mr. Crews did not discuss modifications or exchanges that are
accounted for as an extinguishment. ASC 260-10-S99-2 provides guidance on the EPS impact
of extinguishments (redemptions) of equity-classified preferred stock. Under that
guidance, an SEC registrant compares (1) the fair value of the consideration transferred
to the holders of the preferred stock (i.e., the fair value of the preferred stock
immediately after the modification or exchange along with any other consideration
transferred) and (2) the net carrying amount of the preferred stock immediately before
the modification or exchange (net of issuance costs). The difference is treated as a
return to (or from) the holder of the preferred stock in a manner similar to dividends
paid on preferred stock (i.e., the difference is deducted from net income to arrive at
income available to common stockholders under ASC 260-10-45-11).
Connecting the Dots
Under ASC 260-10-S99-2, the fair value of the consideration transferred to redeem a
preferred stock instrument is presumed to reflect the fair value of the preferred
stock that is being redeemed. If the fair value of the consideration transferred to
preferred stockholders 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.
Below are some examples illustrating modifications and exchanges of
preferred stock. As noted above, when the modification or exchange is treated as an
extinguishment, ASC 260-10-S99-2 applies.
Example 3-25
Modification to Add Mandatory Redemption Feature
Company A adds a mandatory redemption feature to its redeemable preferred stock.
Because the modification results in a requirement to reclassify the modified
instrument from equity to a liability, A concludes that the preferred stock
has been extinguished since an extinguishment has occurred any time a
preferred stock instrument is (1) modified and becomes a
liability-classified instrument or (2) exchanged for an instrument that is
classified as a liability.
Example 3-26
Exchange of Preferred Stock for Common Stock
Company D exchanges its outstanding preferred stock for common stock. This
type of exchange would always be treated as an extinguishment.
ASC 260-10-S99-2 does not apply when a debt instrument is exchanged for a
preferred stock instrument. In accordance with ASC 470-50-40-3, this type of
transaction must be treated as an extinguishment of debt, with a gain or
loss recognized in earnings (unless the transaction reflects a troubled debt
restructuring subject to ASC 470-60).
3.2.6.1.1 Modification or Exchange of Convertible Preferred Stock
An entity may modify the terms of the embedded conversion option in
a convertible preferred stock instrument or achieve the same results by exchanging
convertible preferred stock instruments. An entity may also add or eliminate a
substantive conversion option in a preferred stock instrument through a modification
or exchange. These types of transactions must be assessed to determine whether they
should be treated as an extinguishment.
When a modification or exchange of preferred stock results in the
addition of a conversion option that (1) is substantive as of the date of the
modification or exchange or (2) results in the elimination of a conversion option that
was substantive as of the date of the modification or exchange, the changes to the
terms of the preferred stock are qualitatively significant. In these circumstances,
application of the qualitative approach discussed by the SEC staff (see Section 3.2.6.1) is appropriate
and the modification or exchange is treated as an extinguishment of the existing
preferred stock instrument. Application of the fair value approach to a modification
or exchange of preferred stock that results in the addition or elimination of a
substantive conversion option is generally inappropriate. Application of the cash flow
approach to a modification or exchange of preferred stock that results in the addition
or elimination of a substantive conversion option is never appropriate because this
approach will not reflect any of the value attributable to the impact of the
modification or exchange on the conversion feature.
When a modification or exchange of preferred stock affects the
embedded conversion option in convertible preferred stock (i.e., the preferred stock
contains a substantive conversion feature before and after the modification or
exchange), an entity will often choose to apply the fair value approach discussed by
the SEC staff (see Section
3.2.6.1). When the modification or exchange affects both the embedded
conversion option and the host preferred stock contract, the entity must apply the
fair value approach, as explained by Mr. Crews in his speech (see Section 3.2.6.1).
That is, under the fair value approach, the fair value of the entire preferred stock
instrument is compared on a before-and-after basis to determine whether there is a 10
percent or greater change in the fair value of the entire preferred stock instrument.
However, if the overall change in the fair value of the entire preferred stock
instrument is less than 10 percent or the modification or exchange is determined to
only affect the fair value of the embedded conversion feature, an entity could
consider either of the following approaches:
-
An approach consistent with the approach specified for convertible debt instruments in ASC 470-50-40-10. Under ASC 470-50-40-10, “A modification or an exchange [that] affects the terms of an embedded conversion option, from which the change in the fair value of the embedded conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange) is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange” is accounted for as an extinguishment. Under this approach, the change in the fair value of the embedded conversion feature arising from the modification or exchange is compared with the carrying amount of the convertible preferred stock instrument.
-
An approach that focuses on whether the change to the fair value of the conversion option is 10 percent or more, which is similar to the approach described in the SEC staff speech. Under this approach, the fair value of the embedded conversion option immediately before the modification or exchange is compared with the fair value of the embedded conversion option immediately after the modification or exchange.
Because the SEC staff speech and Codification do not specifically
address how to evaluate the impact of a modification or exchange of convertible
preferred stock that affects the terms of the embedded conversion option, an entity
may consider using either or both of these two approaches. However, in a manner
consistent with the two-step approach outlined in ASC 470-50 for modifications or
exchanges of convertible debt instruments (i.e., a 10 percent cash flow test followed
by a fair value test that focuses only on the impact of the modification or exchange
on the embedded conversion feature), in any modification or exchange of convertible
preferred stock, the evaluation should first focus on the impact of the modification
or exchange on the overall hybrid convertible preferred stock instrument; if that
analysis does not result in extinguishment accounting, a supplemental analysis should
be performed that focuses only on how the modification or exchange affects the terms
of the embedded conversion option. The approaches applied in these analyses could be
the same (i.e., the fair value approach for both analyses) or different (i.e.,
qualitative approach for the overall hybrid convertible preferred stock instrument and
one or more fair value analyses for the effect on the embedded conversion option).
Ultimately, an entity must use judgment and consider all relevant facts and
circumstances in determining whether the modification or exchange reflects an
extinguishment of the convertible preferred stock instrument. In performing these
analyses, the entity should generally apply a consistent approach for similar types of
modifications or exchanges.
If, after evaluating a modification or exchange that involves the
embedded conversion option in convertible preferred stock, an entity concludes that an
extinguishment has not occurred, the entity must determine the appropriate accounting
for the modification or exchange. ASC 470-50-40-15, which addresses modifications or
exchanges that affect the conversion option embedded in a debt instrument, states:
If a convertible debt instrument is modified or exchanged in a
transaction that is not accounted for as an extinguishment, an increase in the fair
value of the embedded conversion option (calculated as the difference between the
fair value of the embedded conversion option immediately before and after the
modification or exchange) shall reduce the carrying amount of the debt instrument
(increasing a debt discount or reducing a debt premium) with a corresponding
increase in additional paid-in capital. However, a decrease in the fair value of an
embedded conversion option resulting from a modification or an exchange shall not be
recognized.
This guidance only specifically addresses the accounting for
modifications or exchanges that affect an embedded conversion option in a debt
instrument. There is no guidance on accounting for a modification or exchange
involving an embedded conversion option in a convertible preferred stock instrument
that is not accounted for as an extinguishment. The SEC staff speech does, however,
discuss modifications and exchanges of preferred stock that are not treated as
extinguishments. As noted in Section
3.2.6.1, any incremental fair value provided to the preferred
stockholders as a result of the modification or exchange is treated as either a
“deemed dividend” or an expense. Considering this guidance, along with the fact that
modifications or exchanges of convertible preferred stock that affect the terms of an
embedded conversion option generally have an impact on the fair value of the overall
hybrid contract that is different from the change in fair value of just the embedded
conversion option, it is most appropriate for the entity to calculate the incremental
fair value, if any, arising from the modification or exchange by comparing the fair
value of the entire convertible preferred stock instrument before and after the
modification or exchange. Any incremental fair value would be treated as a “deemed
dividend” (or potentially as an expense, as discussed in the SEC staff speech), and
the entity would generally not recognize a separate equity component in common
stockholders’ equity as it would if the modification or exchange involved a
convertible debt instrument. This approach is appropriate given its consistency with
the accounting for other types of modifications or exchanges of preferred stock that
are not accounted for as an extinguishment (see Section 3.2.6.1).
When a “deemed dividend” is recognized as a result of the
incremental fair value of a convertible preferred stock instrument that results from a
modification or exchange that involves the embedded conversion option, the amount of
the dividend is accounted for as a reduction of net income in arriving at income
available to common stockholders and increases the carrying amount of the convertible
preferred stock. If the convertible preferred stock is classified in temporary equity
and is being remeasured to its redemption amount under ASC 480-10-S99-3A, the
adjustment from the modification is generally considered part of the “initial amount”
referred to in ASC 480-10-S99-3A(16)(e). That is, any reductions in the carrying
amount of the redeemable equity instrument as a result of the application of the
remeasurement guidance in ASC 480-10-S99-3A would be appropriate only to the extent
that the entity has previously recorded increases in the carrying amount of the
redeemable equity instrument as a result of the application of the remeasurement
guidance in ASC 480-10-S99-3A.
Below are two examples illustrating the accounting for modifications
or exchanges of convertible preferred stock.
Example 3-27
Exchange of Convertible Preferred Stock for Nonconvertible Preferred
Stock
Company B exchanges its 5 percent
cumulative convertible preferred stock for 10 percent nonconvertible
preferred stock. The conversion option in the convertible preferred stock
instrument was a substantive conversion option on the date of the
exchange. The exchange is treated as an extinguishment because the changes
to the terms of the preferred stock include the elimination of a
substantive conversion option.
Example 3-28
Modification of Conversion Price of Convertible Preferred
Stock
Company C modifies its outstanding 6
percent convertible preferred stock by increasing the conversion price and
extending the period over which the investors can convert the preferred
stock into common stock. This extension of the period over which the
investors can convert the preferred stock into common stock has an impact
on the host preferred stock contract because the stated dividend rate does
not reflect a market rate as of the date of the modification.
To determine whether this modification reflects an
extinguishment of the convertible preferred stock, C applies the following
fair-value-based approach:
- Step 1 — Company C first evaluates whether the modification results in a significant change in the fair value of the entire convertible preferred stock instrument and concludes that the change in the fair value of this instrument (calculated on the basis of the fair value of the convertible preferred stock instrument immediately before and immediately after the modification) is less than 10 percent; C therefore proceeds to the next step.
- Step 2 — Company C evaluates whether the modification results in a significant change in the fair value of the embedded conversion option in the convertible preferred stock instrument and concludes that the change in the fair value of this option (calculated on the basis of the fair value of the embedded conversion option immediately before and immediately after the modification) exceeds 10 percent. As a result, C concludes that the modification should be accounted for as an extinguishment.
In reaching a conclusion about whether a modification such as the one discussed
in this example reflects an extinguishment, an entity must use judgment
and consider all relevant facts and circumstances. While C has applied
only a fair value approach, it is important for an entity to also take
qualitative considerations into account. That being said, similar facts
and circumstances should result in similar conclusions (i.e., it would not
be appropriate to “switch” approaches over time to reach different
conclusions regarding whether a modification to convertible preferred
stock represents an extinguishment).
3.2.6.2 Modification or Exchange of Common Stock
Modifications and exchanges of common stock are less common than
modifications and exchanges of preferred stock. Moreover, the treatment of a
modification or exchange of common stock differs from that for preferred stock. As
discussed in Section
3.2.4.3, there is no impact on income available to common stockholders upon
a redemption of common stock unless the fair value of the consideration transferred
exceeds the fair value of the common shares redeemed. Therefore, modifications or
exchanges involving common stock do not need to be evaluated for extinguishment
accounting. Rather, the focus is on whether the modification or exchange results in the
transfer of additional fair value to the holder(s).
When an entity modifies or exchanges common stock and the resulting
impact is an increase in fair value, that increase must be treated as either a “deemed
dividend” or an expense. The appropriate treatment is determined in a manner similar to
the consideration of the appropriate treatment of redemptions of common stock and
modifications and exchanges of preferred stock (see Sections 3.2.4.3 and 3.2.6.1, respectively). If a modification or
exchange is accounted for as a “deemed dividend” to the holder(s), the impact of this
dividend is reflected in the calculation of basic EPS in a manner similar to the
application of the two-class method of calculating EPS. Specifically, if the entity has
multiple classes of common stock and modifies an entire class, the incremental fair
value will be treated as a dividend (i.e., actual distribution) to the modified class,
which will reduce the amount of income available to common stockholders for the class of
common stock that was not modified. If the entity only has a single class of common
stock, it must consider whether the modification results in multiple classes of common
stock to which the two-class method should be applied to appropriately reflect the
impact of the “deemed dividend.”
3.2.6.3 Modification or Exchange of Share-Based Payment Awards
Under ASC 718, modifications to share-based payment awards that result
in an increase in fair value of the award must be accounted for as compensation cost,
either immediately or over the remaining vesting period, depending on the facts and
circumstances. There is no evaluation of whether the modification or exchange results in
an extinguishment of the original award. Furthermore, an entity does not need to make
any incremental adjustments to net income to arrive at income available to common
stockholders. Any effect of the modification is included in net income. For further
discussion of the accounting for modifications of share-based payment awards, see
Chapter 6 of Deloitte’s
Roadmap Share-Based Payment
Awards.
Connecting the Dots
A modification to any award originally issued in a share-based
payment arrangement is always accounted for under ASC 718, even if the modification
occurs after the holder is no longer an employee (or a nonemployee service provider)
and causes the instrument to subsequently become subject to the accounting guidance
on financial instruments. For more information, see Chapter 6 of Deloitte’s Roadmap Share-Based Payment
Awards.
3.2.6.4 Modification or Exchange of Other Potential Common Stock
The table below outlines the accounting that is generally applied to
modifications and exchanges involving other potential common stock instruments that do
not represent share-based payment arrangements.
Table 3-8
Instrument Type
| Evaluate for
Extinguishment Accounting? | Accounting for
Modification or Exchange |
---|---|---|
Convertible debt
| Yes | A modification or
exchange of convertible debt is accounted for in accordance with ASC 470-50.
Whether such a modification or exchange is accounted for as a modification
or as an extinguishment, an entity is not required to make any incremental
adjustment to net income to arrive at income available to common
stockholders. Any effect of the modification or exchange is included in net
income. See Chapter
6 for further discussion of the calculation of basic EPS for
convertible debt instruments. |
Freestanding financial instrument indexed to common stock (e.g., an option or
forward to purchase common stock) — classified as an asset or liability | No |
A freestanding financial instrument indexed to an entity’s
common stock that is classified as an asset or liability will be recognized
at fair value, with changes in fair value recognized in earnings. A
modification or exchange of such an instrument will be reflected through the
change in fair value of the instrument that is recognized in net income.
|
Freestanding financial instrument indexed to common stock (e.g., an option
or forward to purchase common stock) — classified in equity
|
No
|
The Codification addresses an issuer’s accounting for a
modification or exchange of a freestanding equity-classified written call
option that remains equity-classified after the modification or exchange.
ASC 260-10-45-15 states:
For a modification or an
exchange of a freestanding equity-classified written call option described
in paragraph 815-40-35-17(d), an entity shall deduct the effect of the
modification or exchange (as measured in accordance with paragraph
815-40-35-16) in computing income available to common stockholders when
the modification or exchange is executed by the issuer and the holder or
unilaterally by the issuer (see paragraph 815-40-15-7H). Under ASC 815-40 a modification or exchange of a
freestanding equity-classified written call option that remains
equity-classified after the modification or exchange would be accounted for
by recognizing “the excess, if any, of the fair value of the modified or
exchanged instrument over the fair value of that instrument immediately
before it is modified or exchanged. . . . on the basis of the substance of
the transaction, in the same manner as if cash had been paid as
consideration.” Accordingly, an entity accounts for any incremental fair
value provided to the counterparty in a modification or exchange of an
equity-classified written call option. This incremental fair value provided
to the counterparty would be accounted for as a dividend, expense, or
component of a debt modification, or such accounting would otherwise depend
on the facts and circumstances (see ASC 815-40-35-17).
The Codification does not specifically address the accounting for a
modification or exchange of an equity-classified freestanding financial
instrument indexed to an entity’s common stock that is not a written call
option. ASC 260-10-S99-2 does not apply to freestanding financial
instruments indexed to common stock. Rather, it is generally appropriate to
apply ASC 718-20-35-3 by analogy and account for any increase in fair value
as a “deemed dividend” that reduces net income in arriving at income
available to common stockholders (or that is treated as a distribution if
the contract is a participating security). However, in some cases, the
increase in fair value may need to be accounted for as an expense or in
another manner. For considerations related to whether such an amount should
be recognized as a “deemed dividend” or as an expense, see Sections 3.2.4.3 and 3.2.6.1, respectively.
For more information about modifications or exchanges of freestanding
equity-linked instruments, see Sections
6.1.4 and 6.2.4 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
|
Freestanding
financial instrument indexed to preferred stock (e.g., an option or forward
to purchase preferred stock or convertible preferred stock) — classified as
an asset or liability |
No | A freestanding
financial instrument indexed to an entity’s preferred stock that is
classified as an asset or liability will be recognized at fair value, with
changes in fair value recognized in earnings. A modification or exchange of
such an instrument will be reflected through the change in fair value of the
instrument that is recognized in net income. |
Freestanding
financial instrument indexed to preferred stock (e.g., an option or forward
to purchase preferred stock or convertible preferred stock) — classified in
equity | Yes | A modification or
exchange of a freestanding financial instrument indexed to an entity’s
preferred stock that is classified in stockholders’ equity is accounted for
in the same manner as a modification or exchange of preferred stock.
Therefore, a modification or exchange of such an instrument is first
evaluated to determine whether it represents an extinguishment. See
Section
3.2.6.1 for guidance on determining whether a modification or
exchange of preferred stock is accounted for as an extinguishment. If the modification or exchange is treated as an
extinguishment, the difference between the fair value of the “new”
instrument and the net carrying amount of the instrument that was modified
or exchanged is reflected as an adjustment to net income in arriving at
income available to common stockholders in accordance with ASC 260-10-S99-2.
If the modification or exchange is not accounted for
as an extinguishment, any incremental fair value resulting from the
modification or exchange is accounted for as either a “deemed dividend” or
an expense. See Section
3.2.6.1 for further discussion of the accounting for a
modification of preferred stock. |
Connecting the Dots
An equity-classified instrument originally issued in a share-based
payment arrangement becomes subject to the accounting literature applicable to
financial instruments when it was issued to (1) an employee in exchange for services
and its terms are modified when the holder is no longer an employee, (2) a
nonemployee in exchange for goods or services and its terms are modified after the
nonemployee vests in the award and is no longer providing goods or services, or (3)
a grantee that is no longer a customer and its terms are modified after the grantee
vests in the award and both of the following conditions are
not met: (a) there is no increase in fair value of the award (or the ratio of
intrinsic value to the exercise price of the award is preserved — that is, the
holder is made whole) or the antidilution provision is not added to the terms of the
award in contemplation of an equity restructuring and (b) all holders of the same
class of equity instruments (e.g., stock options) are treated in the same manner
(see ASC 718-10-35-10).
3.2.6.5 Reclassification of Other Potential Common Stock
The table below describes whether ASC 260-10-S99-2 applies when an
embedded conversion option indexed to the reporting entity’s stock is reclassified
between an equity instrument and a derivative liability for reasons other than a
modification or exchange involving the instrument.
Table 3-9
Instrument
Type | Underlying | Reclassification | Whether ASC
260-10-S99-2 Applies as of the Reclassification Date |
---|---|---|---|
Convertible debt | Indexed
to common stock | From: One liability instrument To: Debt host contract and conversion option
derivative liability | No. ASC 815-15 applies to the separation of the embedded conversion
option as a derivative liability. ASC 260-10-S99-2 does not apply to the
separation of the embedded conversion option. See Chapter 6 for further discussion of the
calculation of basic EPS for convertible debt instruments. |
From: Debt host contract and conversion option derivative liability
To: Debt host contract and
equity component | No. Footnote 18 of EITF Topic D-98 states that “Topic
D-42 [which was codified in ASC 260-10-S99-2] also does not apply to
convertible debt instruments that contain an embedded conversion option
indexed to the issuer’s common stock because the application of EITF Topic
D-42 is limited to preferred stock instruments.” Therefore, ASC 260-10-S99-2
does not apply to the reclassification of the embedded conversion option
from a separated derivative liability to an equity component. However, ASC
480-10- S99-3A(12)(d) and 3A(16)(d) would apply to the equity component
after the reclassification if it is currently redeemable for cash or other
assets. See Chapter
6 for further discussion of the calculation of basic EPS for
convertible debt instruments. | ||
From: Debt host component and equity component To: Debt host contract and conversion option
derivative liability | No. As indicated in ASC 480-10-S99-3A(23), “there should be no incremental earnings per share accounting from the application of this SEC staff announcement” to convertible debt that contains a separated equity component that is indexed to the issuer’s common stock. Furthermore, footnote 18 of EITF Topic D-98 states that “Topic D-42 [which was codified
in ASC 260-10-S99-2] also does not apply to convertible debt instruments that contain an embedded conversion option indexed to the issuer’s common stock because the application of Topic D-42 is limited to preferred stock
instruments.” Therefore, ASC 260-10-S99-2 does not apply to this
reclassification. While ASC 480-10-S99-3A(12)(d) and 3A(16)(d) would have
applied to the equity component in periods before the reclassification if it
was currently redeemable for cash or other assets, that guidance would no
longer apply after the reclassification since there is no longer any equity
component reported for the instrument. See Chapter 6 for further discussion of the
calculation of basic EPS for convertible debt instruments. | ||
Convertible preferred stock | Indexed
to common stock | From: Debt host component and equity component (i.e.,
the principal amount of the convertible preferred stock must be settled in
cash) To: Debt host contract and conversion option
derivative liability | No. Although preferred stock in legal form, since the
instrument is classified as a liability, the accounting is the same as the
accounting for the reclassification of the equity component of convertible
debt that contains a separated equity component to a derivative liability.
See Chapter 6
for further discussion of the calculation of basic EPS for convertible debt
instruments. |
From: One preferred equity instrument To: Preferred equity host contract and conversion
option derivative liability | No. ASC 260-10-S99-2 may seem to apply because, before the separation
of the embedded conversion option, the instrument represented preferred
stock classified in equity (either permanent or temporary equity) and the
separation of the embedded derivative is akin to the transaction discussed
in the scope section of ASC 260-10-S99-2 (i.e., when an equity-classified
security must be subsequently reclassified as a liability). However, because
the entry recognized under ASC 815-15 to separate the conversion option
liability is a debit to preferred stock and a credit to a derivative
liability at the fair value of the derivative, the application of ASC
260-10-S99-2 would have no impact on the date of separation. The separation
could, however, affect the subsequent accounting for the convertible
preferred stock instrument under ASC 260-10-S99-2 and ASC 480-10-S99-3A.
If the convertible preferred stock is classified in
temporary equity and is being remeasured to its redemption amount, the
entity should perform one last remeasurement under ASC 480-10-S99-3A
immediately before separating the conversion option liability. ASC
480-10-S99-3A would continue to apply to the preferred stock host contract
if it was redeemable for cash or other assets. See
Sections
3.2.2.5.4.1, 3.2.2.6.2.1.1, and 3.2.2.6.3.1 for discussion of the
accounting for the settlement of the instrument. | ||
From: Preferred equity host contract and equity component classified
in common stockholders’ equity To: Preferred equity host contract and conversion option derivative
liability | No. Since the equity component is indexed to common stock, the reclassification to a liability is not subject to ASC 260-10-S99-2 because that guidance applies only to preferred stock (as discussed in footnote 18 of EITF Topic D-98). After the reclassification,
ASC 480-10-S99-3A may continue to apply to the preferred stock host
contract. ASC 480-10-S99-3A may have also been applicable before this
reclassification. See Sections 3.2.2.5.4.1, 3.2.2.6.2.1.1, and
3.2.2.6.3.1
for discussion of the accounting for the settlement of the instrument.
Note that this type of reclassification would not be
common in practice. | ||
From: Preferred equity host contract and conversion option derivative
liability To: Preferred
equity host contract and equity component classified in common stockholders’
equity | No. By analogy to ASC 815-15-35-4, the embedded
conversion option should be reclassified from a derivative liability to
common stockholders’ equity. ASC 260-10-S99-2 does not apply to this
reclassification because that guidance does not apply to (1) a conversion
option that is indexed to common stock or (2) a reclassification of a
liability to an equity instrument, which is not considered a redemption of
preferred stock. However, ASC 480-10-S99-3A would apply after the
reclassification if the convertible preferred stock is redeemable for cash
or other assets. ASC 480-10-S99-3A may have also been applicable before this
reclassification. See Section 3.2.5.2.4 for discussion of the
accounting for the settlement of the instrument. | ||
Indexed
to preferred stock | From: One preferred equity instrument To: Preferred equity host contract and conversion
option derivative liability | No. ASC 260-10-S99-2 may seem to apply because, before the separation
of the embedded conversion option, the instrument represented preferred
stock classified in equity (either permanent or temporary equity) and the
separation of the embedded derivative is akin to the transaction discussed
in the scope section of ASC 260-10-S99-2 (i.e., when an equity-classified
preferred stock instrument must be subsequently reclassified as a
liability). However, because the entry recognized under ASC 815-15 to
separate the conversion option liability is a debit to preferred stock and a
credit to derivative liability at the fair value of the derivative, the
application of ASC 260-10-S99-2 would have no impact on the date of
separation. The separation could, however, affect the subsequent accounting
for the convertible preferred stock instrument under ASC 260-10-S99-2 and
ASC 480-10-S99-3A. If the convertible preferred
stock is classified in temporary equity and is being remeasured to its
redemption amount, the entity should perform one last remeasurement under
ASC 480-10-S99-3A before separating the conversion option liability. ASC
480-10-S99-3A would continue to apply to the preferred stock host contract
if it is redeemable for cash or other assets. See
Sections
3.2.2.5.4.1, 3.2.2.6.2.1.1, and 3.2.2.6.3.1 for discussion of the
accounting for the settlement of the instrument. | |
From: Preferred equity host contract and conversion option derivative
liability To: Preferred
equity host contract and equity component classified in preferred
stockholders’ equity | No. By analogy to ASC 815-15-35-4, the embedded
conversion option should be reclassified from a derivative liability to
preferred stockholders’ equity. ASC 260-10-S99-2 does not apply to this
reclassification because that guidance does not apply to a reclassification
of a liability to an equity instrument, which is not considered a redemption
of preferred stock. However, ASC 480-10-S99-3A would apply after the
reclassification if the convertible preferred stock is redeemable for cash
or other assets. ASC 480-10-S99-3A may have also been applicable before this
reclassification. See Section 3.2.5.2.5 for
discussion of the accounting for the settlement of the instrument. Note that this type of reclassification would not be common
in practice. | ||
Freestanding financial instrument
|
Indexed to common stock
| From: Asset or liability To: Equity | No. The reclassification of the instrument from an asset or liability
to an equity-classified instrument is not subject to ASC 260-10-S99-2
because that guidance does not apply to a reclassification of an asset or
liability to equity. ASC 815-40-35-10 addresses the reclassification of an
equity-linked instrument from an asset or liability to equity. See Section 3.2.5.2.1 for discussion of the accounting for the
settlement of the instrument. |
From: Equity To:
Asset or liability | No. Footnote 18 of EITF Topic D-98 states, in part, that “the application of Topic D-42 [which was codified in ASC 260-10-S99-2] is
limited to preferred stock instruments.” ASC 815-40-35-9 addresses the
reclassification of an equity-linked instrument from equity to an asset or
liability. See Section 3.2.5.2 for discussion of the
accounting for the settlement of the instrument. | ||
Indexed to preferred stock
| From: Asset or liability To: Equity | No. The reclassification of the instrument from an asset or liability
to an equity-classified instrument is not subject to ASC 260-10-S99-2
because that guidance does not apply to a reclassification of an asset or
liability to equity. See Section 3.2.5.2.2 for discussion of the
accounting for the settlement of the instrument. | |
From: Equity To:
Asset or liability | Yes. This type of reclassification is akin to the transaction
discussed in the scope section of ASC 260-10-S99-2 (i.e., when an
equity-classified preferred stock instrument must be subsequently
reclassified as a liability on the basis of the provisions of other GAAP).
See further discussion of this type of reclassification in Section 3.2.2.8. See
Section
3.2.5.2 for discussion of the accounting for the settlement of
the instrument. |
3.2.7 Summary of Scope of ASC 260-10-S99-2
The table below summarizes the scope of ASC 260-10-S99-2 with respect to
financial instruments that do not represent an NCI. For purposes of the discussion in this
table, unless otherwise stated, any embedded conversion option is indexed to and settled
in the entity’s common stock and is not accounted for separately from the host contract.
While ASC 260-10-S99-2 may not be applicable, for certain transaction types, other
relevant GAAP may still result in an impact on net income or income available to common
stockholders as a result of the settlement. Although the table below does not discuss the
application of ASC 480-10-S99-3A, the sections referred to in the table do discuss such
application.
For NCIs, the accounting at the subsidiary level may affect the parent’s
EPS. For discussion of NCIs, see Section
3.2.3.
Table 3-10
Transaction
Type | Subject to ASC
260-10-S99-2 | Not Subject to ASC
260-10-S99-2 |
---|---|---|
Conversion
(or exercise) |
|
|
Redemption
(including a modification or exchange accounted for as an extinguishment)
Note that any modification or exchange that is not
accounted for as an extinguishment is not within the scope of ASC
260-10-S99-2. However, for accounting purposes, an entity generally accounts
for such modifications or exchanges when they result in an increase in the
fair value of the instrument. The impact depends on the nature of the
instrument modified. See Section 3.2.6 for additional information. |
|
|
Inducement
offer |
|
|
Reclassification |
|
|
Footnotes
1
These items affect income available to common
stockholders either directly (i.e., adjustments to net income to arrive at
income available to common stockholders) or indirectly (i.e., adjustments
to net income).
2
This Roadmap does not address the date on which
cumulative dividends must be recognized by an entity as either a
liability or shares of stock. The balance sheet recognition of
dividends on cumulative preferred stock will depend on the relevant
terms of the preferred stock instrument, including whether dividends
must be declared before payment. For guidance on when dividend
obligations should be recognized as a liability on the balance sheet,
see 505-10-05 (Q&A 08) in
Deloitte’s FASB Accounting Standards Codification Manual on
DART.
3
A contingency is an event that is not solely within
the control of the issuer or holder of the preferred stock.
4
The preferred stock is not considered increasing-rate preferred
stock merely because the carrying amount is at a discount to the liquidation
preference. See further discussion in Section 3.2.2.3.
5
In all circumstances, an entity should adjust the fair value
of the derivative liability through net income immediately before accounting for
the settlement.
6
A convertible preferred stock instrument may contain a
component that has been separately recognized in common stockholders’
equity. Upon conversion, in conjunction with other relevant guidance, an
entity is required to recognize any remaining unamortized discount on the
convertible preferred stock as a reduction to net income in arriving at
income available to common stockholders. Thus, while ASC 260-10-S99-2 does
not apply to a conversion, other guidance requires accounting that results
in a “deemed dividend” in a manner similar to the accounting under ASC
260-10-S99-2. See Section
3.2.5.2.4 for further discussion of this guidance, which
applies to all entities and not just SEC registrants.
7
See Section 3.2.5.2.3 for discussion of convertible debt that
contains a separately classified equity component.
8
ASC 260-10-S99-2 applies to the consolidated financial
statements of a parent in the period that includes a modification, an
extinguishment, or an induced conversion of preferred stock issued by a
consolidated subsidiary that is classified as an NCI.
9
If only the parent absorbed the impact of a dividend or “deemed
dividend,” an allocation to NCIs in the form of common stock is not
appropriate.
10
See Section
3.2.4.3.1 for guidance on situations in which the repurchase occurs on
the basis of the settlement of a forward contract to repurchase common stock.
11
For example, assume that the holder of the shares is a private equity
firm and that the issuer repurchases the shares to prevent the holder from
obtaining additional board representation or other influence over the
entity. The entity should compare the repurchase price with the amount
that would be paid to a holder of those shares in a transaction that is
not executed to prevent additional board representation or other influence
over the entity. It would not be appropriate for the issuer to assume that
other private equity investors would also demand repurchase at the same
price to avoid obtaining additional board representation or other
influence over the entity.
12
Depending on the facts and circumstances, the inducement charge
may need to be recognized in earnings rather than being treated as a dividend.
13
Footnote 18 of EITF Topic D-98 is not codified. See Section 3.2.5.2.3 for further
discussion of the applicability of this guidance.
14
Allocating to the separately recognized equity
component an amount equal to the amount initially recognized for
that component differs from the accounting for a redemption of a
convertible preferred stock instrument that contains an embedded
conversion option that has been reclassified from a derivative
liability to a separate component of common stockholders’ equity
(discussed below). This difference is justified because only the
incremental fair value of the embedded conversion option, as
opposed to its entire fair value, is recognized as a result of
the modification or exchange that affects the embedded
conversion option in a convertible preferred stock instrument.
15
Since the SEC staff has not previously
expressed any view on the redemption of convertible preferred
stock that contains a separately recognized equity component as
a result of a reclassification of the embedded derivative from a
liability to equity, it is appropriate to allocate an amount to
the equity component on the basis of its fair value on the
redemption date in a manner similar to the accounting applied to
convertible debt, as discussed in ASC 815-15-40-4.
16
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.5.2.4, the issuer in a conversion should
immediately amortize any remaining unamortized discount on the
preferred stock host, which will be treated as a dividend for which
net income is adjusted to arrive at income available to common
stockholders.
17
See footnote 16 for the accounting for the
settlement of the host contract component.
18
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.2.5.4.1, in a conversion accounted for under this
method, the issuer should immediately amortize any remaining
unamortized discount on the preferred stock host, which will be
treated as a dividend for which net income is adjusted to arrive at
income available to common stockholders.
19
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.4.3, the recognition of a dividend or an expense
may be required for a repurchase of common stock for an amount that
exceeds the fair value of the common stock repurchased.
20
While ASC 260-10-S99-2 does not apply, as noted in
Chapter
6, an expense must be recognized for an induced
conversion of a convertible debt instrument.
21
See footnote 20.
22
See footnote 20.
23
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.2.6.3.1, an inducement will affect net income
through the mark-to-market adjustment on the derivative
liability.
24
While ASC 260-10-S99-2 does not apply, if an
entity settles an equity-classified contract indexed to its common
stock under an inducement offer, the additional value resulting from
the inducement should be treated as a dividend or an expense. If the
value is recognized as a dividend, the amount of the dividend should
result in an adjustment to net income to arrive at income available
to common stockholders.
25
See footnote 23.
26
See footnote 23.
27
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.4.1, the additional value resulting from an induced
conversion of one class of common stock into another should be
accounted for as either a dividend through application of the
two-class method of calculating basic EPS or as an expense in a
manner consistent with the accounting for reacquisitions of common
stock at a price that exceeds fair value.
3.3 Weighted-Average Number of Shares Outstanding
3.3.1 General
ASC 260-10
Computing a Weighted-Average
55-2 The weighted-average number of shares is an arithmetical mean average of shares outstanding and assumed to be outstanding for EPS computations. The most precise average would be the sum of the shares determined on a daily basis divided by the number of days in the period. Less-precise averaging methods may be used, however, as long as they produce reasonable results. Methods that introduce artificial weighting, such as the Rule of 78 method, are not acceptable for computing a weighted-average number of shares for EPS computations.
The denominator in the calculation of basic EPS is based on the weighted-average
number of common shares outstanding during the period. The denominator for basic
EPS does not include potential common stock. As discussed in Section 3.1.1, the
determination of whether an equity security meets the ASC 260-10-20 definition
of common stock should be based on the substance of the instrument in addition
to its legal form. There may be circumstances in which (1) equity shares in the
legal form of preferred stock do not have a substantive liquidation preference
and share all of the characteristics of common stock or (2) an equity security
represents a common equity instrument in legal form but has a substantive
liquidation preference and other characteristics of preferred stock. If an
equity security represents preferred stock in legal form but has all the
characteristics of common stock in its current form, it should be considered an
outstanding share of common stock in the calculation of basic EPS. Similarly, if
an equity security represents common stock in legal form but has all the
characteristics of preferred stock in its current form, it should not be
considered an outstanding share of common stock in the calculation of basic EPS.
In the situations discussed in the preceding two sentences, an entity may be
required to use the two-class method of calculating basic EPS.
In addition to evaluating whether an equity security meets the definition of common stock, an entity must consider a number of other matters in determining the number of shares of common stock included in the denominator in the calculation of basic EPS. Those matters include the following:
3.3.2 Determining Whether Common Shares Are Outstanding
Questions may arise about whether certain types of equity securities should be considered outstanding shares of common stock in the calculation of the weighted-average number of common shares outstanding.
3.3.2.1 Redeemable Common Stock
Shares of redeemable common stock that are legally issued and outstanding should be considered outstanding in the calculation of the weighted-average number of common shares outstanding since such shares represent common stock in both legal form and substance. The only exceptions are if (1) the shares have been legally issued but are subject to vesting conditions under the accounting guidance for share-based payment awards or (2) the shares meet the definition of a mandatorily redeemable financial instrument in ASC 480 and are classified as a liability. See also Example 3-20.
3.3.2.2 Mandatorily Convertible Instruments
An entity may have issued instruments that are mandatorily convertible into common stock. These instruments could include preferred stock or debt that is mandatorily convertible into common stock at a future date or common stock that is mandatorily convertible into another class of common stock at a future date. Even though conversion into shares of common stock will occur upon the mere passage of time, the outstanding shares of common stock included in the denominator in the calculation of basic EPS should be determined on the basis of the current form of the instrument. Therefore, shares of common stock underlying a mandatorily convertible preferred stock or debt instrument should not be included in the denominator in the calculation of basic EPS; however, the two-class method of calculating basic EPS is required if the mandatorily convertible instrument meets the definition of a participating security. Similarly, shares of a second class of common stock underlying a mandatorily convertible common stock instrument should not be included in the outstanding shares of the second class of common stock. However, the mandatorily convertible common stock instrument is considered outstanding common stock. In this circumstance, the two-class method of calculating EPS is required. See Chapter 5 for discussion of participating securities and the two-class method of calculating EPS.
Connecting the Dots
The treatment of mandatorily convertible instruments in the calculation of basic EPS is consistent with the accounting guidance that the FASB proposed in its August 7, 2008, exposure draft as part of a convergence project with the IASB. While that proposed guidance was never issued in final form, we understand that the SEC staff has previously concluded that an entity should not consider common stock as outstanding shares in the denominator in the calculation of basic EPS when those shares will be issued in the future upon a mandatory conversion or an exchange of another outstanding instrument. We understand that this view is based on the fact that the shares of common stock are not legally outstanding before the conversion or exchange, and the guidance on contingently issuable shares does not apply because there are no contingencies or uncertainties related to the ultimate issuance of such shares of common stock.
3.3.2.3 Share-Based Payment Awards
3.3.2.3.1 Nonvested Share Awards
During the requisite service period or nonemployee’s
vesting period, share-based payment awards do not affect the denominator
in the calculation of basic EPS. Once the awards are vested, the shares
of common stock that have been legally issued are considered outstanding
shares and are included in the denominator in the calculation of basic
EPS. That is, while nonvested shares of common stock that vest solely on
the basis of a service condition are not included in the denominator in
the calculation of basic EPS during the requisite service period or
nonemployee’s vesting period even if the shares have been legally
issued, once the goods are delivered or the service period is complete,
the shares become outstanding common stock and are included in the
weighted-average number of common shares outstanding. This is the case
even if the awards contain clawback features (see Section 7.1.1).
Such awards will be included in the weighted-average number of common
shares from the date on which they become vested outstanding common
shares. Although nonvested shares are not considered outstanding with
respect to the denominator in the calculation of basic EPS, all
outstanding nonvested shares that contain nonforfeitable rights to
dividends or dividend equivalents, when dividends are declared on shares
of common stock, are considered participating securities. Because the
nonvested shares are considered participating securities, the issuing
entity is required to apply the two-class method to calculate EPS. See
Section
7.1.3.1 for further discussion of when share-based
payment awards represent a participating security.
3.3.2.3.2 Stock Options
Share-based payment awards in the form of stock options
are not included in the denominator in the calculation of basic EPS,
whether the awards are vested or unvested. The same is true of
liability-classified share-based payment awards. However, stock option
awards and liability-classified awards could also meet the definition of
a participating security to which an entity is required to apply the
two-class method of calculating basic EPS.
3.3.2.3.3 Retirement-Eligible Employees
Awards of shares to employees that vest when the grantee becomes eligible
for retirement must be considered outstanding shares in the denominator
of basic EPS as of the date the grantee is eligible to retire and retain
the shares. This is because, once the employee is eligible to retire,
there are no conditions that must be met for the common stock to be
issued. Such shares are not considered contingently issuable shares
since an agreement that requires an entity to issue common shares only
after the mere passage of time is not considered a contingently issuable
share arrangement. In other words, no remaining service period is
associated with the issuance of the shares since the holder can retire
at any time and receive the shares.
3.3.2.4 Other Compensatory Arrangements
Section 7.2 discusses when common stock held by an employee stock ownership plan (ESOP) should be outstanding in the calculation of basic EPS. Section 7.3 discusses the impact that other compensatory arrangements, including profits interests and common stock owned by a rabbi trust, have on the calculation of basic EPS.
3.3.2.5 Contingently Issuable Shares
ASC 260-10
Treatment of
Contingently Issuable Shares in Weighted-Average
Shares Outstanding
45-12C Contractual agreements
(usually associated with purchase business
combinations) sometimes provide for the issuance of
additional common shares contingent upon certain
conditions being met. Consistent with the objective
that basic EPS should represent a measure of the
performance of an entity over a specific reporting
period, contingently issuable shares should be
included in basic EPS only when there is no
circumstance under which those shares would not be
issued and basic EPS should not be restated for
changed circumstances.
45-13 Shares issuable for
little or no cash consideration upon the
satisfaction of certain conditions (contingently
issuable shares) shall be considered outstanding
common shares and included in the computation of
basic EPS as of the date that all necessary
conditions have been satisfied (in essence, when
issuance of the shares is no longer contingent).
Outstanding common shares that are contingently
returnable (that is, subject to recall) shall be
treated in the same manner as contingently issuable
shares. Thus, contingently issuable shares include
shares that meet any of the following criteria:
-
They will be issued in the future upon the satisfaction of specified conditions.
-
They have been placed in escrow and all or part must be returned if specified conditions are not met.
-
They have been issued but the holder must return all or part if specified conditions are not met.
Contingently issuable shares include:
-
Shares that will be issued in the future on the basis of the satisfaction of specified conditions (e.g., common shares issuable to a customer if certain levels of purchases are reached or common shares issuable to the seller of a business if the issuer’s common stock price does not increase by a specified date).
-
Shares that have been issued but that must be returned to the issuer if certain specified conditions occur or fail to occur.
The ASC 260 EPS guidance on contingently
issuable shares does not apply to the following:
-
Shares issuable solely upon the passage of time. (While contingent issuances of shares are usually based on the passage of time and another specified condition, shares issuable upon the mere passage of time are not contingently issuable because the passage of time is certain to occur.)
-
Share-based payment arrangements that are subject to ASC 718, including shares that vest on the basis of only a service condition and shares that have vested but that are subject to clawback provisions. (The relevant guidance on share-based payments applies to these arrangements.)
In accordance with ASC 260-10-45-12C and 45-13, when an entity is
contingently obligated to issue shares of common stock (i.e., the issuance
of common shares will occur only upon resolution of a substantive
contingency), those shares of common stock are not included in the
outstanding shares of common stock in the denominator in the calculation of
basic EPS. In other words, contractual arrangements that meet the definition
of contingently issuable shares are not outstanding shares of common stock
because ASC 260-10-45-12C specifies that “contingently issuable shares
should be included in basic EPS only when there is no circumstance under
which those shares would not be issued.” Thus, the outstanding common stock
of an entity includes such shares only when they are no longer contingently
issuable. Shares of common stock that are legally issued and outstanding but
contingently returnable are treated in the same manner as contingently
issuable shares. When the contingencies associated with contingently
issuable or contingently returnable shares are resolved, the shares of
common stock should be included in the calculation of weighted-average
common shares. Such shares are included in outstanding shares in the
calculation of basic EPS beginning on the date the last contingency was
resolved.
See Section 3.3.2.3.3 for discussion of
common stock held by retirement-eligible employees. See Section 7.1.1 for
discussion of the treatment of clawback features associated with vested
share-based payment awards.
The examples below illustrate application of the ASC 260
guidance on contingently issuable shares.
Example 3-29
Calculating
Basic EPS When Issuance of Shares Is Contingent on
Attainment of Future Earnings
Company X, which reports on a
calendar-year basis, purchased Subsidiary Y on
January 1 for $100 million plus 20,000 shares of X’s
common stock for each year within the next five
years in which Y has net income of $10 million or
more. By June 30 of year 1, Y has net income of $15
million.
While the 20,000 shares of X’s
common stock would be issuable if the end of the
contingency period were June 30 instead of December
31, the 20,000 common shares should be excluded from
basic EPS for the six months ended June 30, because
events could occur in the next six months that would
cause X not to issue the shares (i.e., Y could lose
$6 million in the next six months).
If Y’s net income for the year ended
December 31 was $12 million, the shares would be
included in the denominator for basic EPS for only
that portion of the year for which the contingency
was resolved (i.e., nothing could happen that would
cause X not to issue the shares). See Example
4-17 for an illustration of the
calculation of diluted EPS.
Because there are five separate
measurement periods for the contingency, each
measurement period in which a finite number of
common shares may be issued should be treated as a
separate contingency and evaluated on the basis of
whether X may be required to issue the common shares
for each period on a stand-alone basis for basic
EPS. If the purchase agreement required X to issue
100,000 shares of its common stock if Y achieved $50
million in cumulative net income at the end of five
years, no shares would be included in basic EPS
until the end of the contingency period and then
only if Y had cumulative earnings in excess of $50
million.
In the calculation of basic EPS,
shares that are contingently returnable should not
be considered outstanding for basic EPS until the
conditions under which return of the shares is
required have been satisfied. Thus, if the shares
discussed above had been legally issued and placed
into escrow, the accounting conclusion above would
not be affected.
Example 3-30
Calculating
Basic EPS When Issuance of Shares Is Contingent on
Continued Employment
Company M has a mandatory deferred
compensation plan under which covered employees are
required to defer the amount of compensation payable
in one calendar year in excess of $1 million until
completion of the deferral period. The deferral
period ends when the employee ceases to earn $1
million annually or reaches the defined retirement
age as an employee of M. If the employee is
terminated or resigns, he or she is not eligible to
receive any distribution under the plan. The
compensation deferred under the plan is only payable
to the participant in shares of M’s common stock
over a five-year period once the participant is
eligible to receive the distribution.
A participant’s deferred
compensation is held in an escrow account until the
individual is eligible to receive distributions. The
escrow account does not bear interest; however, it
receives the dividend equivalent on the basis of the
equivalent number of common stock into which the
cash value of the account would be converted,
depending on the closing price of the common stock
on the NYSE for the trading day preceding the
original deferral. Distributions from the account
are based on the equivalent number of common shares
that the cash value of the distribution would
convert into, depending on the closing price of the
stock on the NYSE for the trading day preceding the
distribution.
The common stock issuable under the
plan is considered contingently issuable shares
because the common stock will not be issued if the
employee is terminated or resigns from M’s
employment before retirement. The shares issuable
under the plan should be excluded from the
calculation of basic EPS because it is possible that
the employee will never receive the shares.
Further, the number of shares
contingently issuable may depend on the market price
of the stock at a future date. If the market price
may change in a future period, such contingently
issuable shares should not be included in basic EPS
because all necessary conditions have not been
satisfied. See Example 4-24 for
the effect of contingently issuable securities on
diluted EPS.
In addition, outstanding common
shares that are contingently returnable (i.e.,
subject to recall) should be treated in the same
manner as contingently issuable shares. If shares
are returnable or placed in escrow until they are
vested or some other contingent criteria are met,
the shares should be excluded from the denominator
in the computation of basic EPS even if they have
been issued.
3.3.2.5.1 Shares Issuable for Little or No Consideration
Shares issuable for little or no consideration that do
not contain any conditions that must be satisfied for the holder to
ultimately receive (or retain) the shares are not considered
contingently issuable. ASC 260-10-45-13 states, in part, that “shares
issuable for little or no cash consideration [that are not contingently
issuable shares] shall be considered outstanding common shares and
included in the computation of basic EPS.” In this section, it is
assumed that shares issuable for little or no consideration do not
contain any vesting conditions.
In determining the appropriate accounting for shares
issuable for little or no consideration, an entity must first assess
whether the issuance constitutes a nominal issuance of common stock. If
so, the shares of common stock are considered outstanding
retrospectively for all prior reporting periods presented. Section 8.3.4
discusses nominal issuances of common stock.
If the issuance is not considered nominal, the entity must determine
whether the consideration that must be paid for the holder to receive
the shares is “little or none.” Accordingly, the entity is required to
compare the consideration that must be paid by the holder with the fair
value of the shares of common stock to be received. This comparison is
only performed at the inception of the instrument on the basis of the
fair value of the common stock to be received on that date. Reassessment
is only necessary if the instrument is modified.
An entity must use judgment to determine the meaning of “little or none”
in this context. We believe that “little or none” generally means
“nonsubstantive.” If the consideration that must be paid for the holder
to receive the shares is determined to be “little or none,” the related
shares are considered outstanding with respect to the denominator in the
calculation of basic EPS.
Connecting the Dots
It is not appropriate to exclude from the denominator in the
calculation of basic EPS common shares that are issuable for
little or no consideration on the basis of any of the following:
- Beneficial ownership limitations that apply to the holder.
- The holder paid the entity a substantive amount to acquire the instrument.
- Conditions outside the share issuance agreement that could affect the holder’s ability or intent to ultimately acquire the underlying common shares.
Some entities issue options or warrants with an exercise price of $0.01
or less. Such instruments are often referred to as “penny warrants.”
Unless the issuer’s stock price is also nominal, the shares issuable
under equity-classified penny warrants must be included in the
denominator in the calculation of basic EPS. Diversity in practice may
exist with respect to whether the shares issuable under
liability-classified penny warrants that are measured at fair value
through earnings are reflected in the denominator in the calculation of
basic EPS. However, if such shares are not included in the denominator,
such instruments will typically be considered participating securities
because the holder would be economically compelled to exercise the
warrants if the entity declares a dividend. See Chapter 5 for more information about the
two-class method of calculating EPS.
The example below
illustrates the accounting for penny warrants.
Example 3-31
Penny
Warrants
Company G issues $100 million of
convertible debt with equity-classified detachable
warrants. The warrants enable the investors in the
convertible debt to acquire 10 million shares of
G’s common stock at an exercise price per share of
$0.01. On the date of issuance, the quoted market
price of G’s common stock is $25 per share. The
warrants are not considered to reflect a nominal
issuance of common stock.
The warrants are not
contingently issuable shares because no conditions
must be met before the underlying common stock is
issued. (This would be true even if the holder’s
ability to exercise the warrants is subject to a
beneficial ownership limitation, because the
holder would be able to sell shares to fully
exercise the warrants.) The exercise of the
warrants is virtually certain because the exercise
price is clearly nonsubstantive in relation to the
fair value of the common shares to be issued upon
exercise. Because G’s common stock will be issued
for little or no consideration, the shares
underlying the warrants should be considered
outstanding in the denominator in the calculation
of basic EPS from the issuance date of the
warrant. This conclusion would apply regardless of
whether the warrants are immediately exercisable
or will become exercisable on a future date on the
basis of the mere passage of time.
If the investors’ ability to
exercise the warrants depends on the satisfaction
of certain conditions, all of the necessary
conditions for issuance of the underlying common
shares would not be met as of the date the
warrants are issued and the shares underlying the
warrants should not be included in the denominator
in the calculation of basic EPS. In such
circumstances, the warrants represent contingently
issuable shares.
3.3.2.6 Common Stock Subscriptions
Stock subscriptions allow entities 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 EPS depends on whether (1) the investor is entitled to participate in dividends before the subscription agreement is fully paid and (2) the shares of common stock are legally issued and outstanding. Generally, the shares of common stock underlying a fully unpaid stock subscription agreement have no impact on the denominator in the calculation of basic EPS; however, the two-class method may need to be applied if the arrangement represents a participating security. For partially paid stock subscription agreements, the common-share equivalent of the paid portion should generally be treated as outstanding shares of common stock if the investor is entitled to participate in dividends on that portion. See further discussion in Section 8.3.1.
3.3.2.7 Common Stock Issued for Note Receivable
The facts and circumstances associated with legally outstanding common stock that was issued in return for a note receivable will vary depending on the contractual terms of the arrangement. ASC 260 does not provide specific guidance on situations in which an entity has issued shares of common stock to
an investor that are legally outstanding and not subject to any vesting conditions in return for a note receivable. The determination of whether common shares issued in return for a note receivable should be considered outstanding and included in the denominator in the calculation of basic EPS, or should be treated as contingently issuable shares, depends on whether the entity has the ability and intent to cancel the shares if the note receivable is not repaid. See further discussion in Section 8.3.2.
3.3.2.8 An Entity’s Own Share Lending
An entity may loan its shares of common stock to an investment bank or third-party investor in conjunction with the issuance of convertible debt. Such shares are “loaned” because the investment bank or investor is unable to borrow shares in the market to hedge its exposure to the conversion option in the issuer’s convertible debt or because the borrowing cost is prohibitive. As noted in ASC 470-20-05-12B, although the “loaned” shares are legally issued and outstanding, those shares are generally not considered outstanding shares of common stock in the calculation of basic EPS. See further discussion in Section 8.5.
3.3.3 Repurchases of Common Stock
3.3.3.1 Shares of Common Stock That Have Been Repurchased
ASC 260-10-45-10 indicates that “[s]hares issued during the period and shares reacquired during the period shall be weighted for the portion of the period that they were outstanding.” Therefore, the weighted-average common shares outstanding should reflect the reduction of outstanding shares of common stock from the reacquisition date, whether the reacquired shares are canceled or held in treasury. Such repurchases include the shares of common stock acquired in the treasury stock component of an accelerated share repurchase program. See Section 8.4.1 for additional discussion of accelerated share repurchase programs.
3.3.3.2 Forwards to Repurchase Common Stock
ASC 480-10
EPS
45-4 Entities that have
issued mandatorily redeemable shares of common stock
or entered into forward contracts that require
physical settlement by repurchase of a fixed number
of the issuer’s equity shares of common stock in
exchange for cash shall exclude the common shares
that are to be redeemed or repurchased in
calculating basic and diluted earnings per share
(EPS). Any amounts, including contractual
(accumulated) dividends and participation rights in
undistributed earnings, attributable to shares that
are to be redeemed or repurchased that have not been
recognized as interest costs in accordance with
paragraph 480-10-35-3 shall be deducted in computing
income available to common shareholders (the
numerator of the EPS calculation), consistently with
the two-class method set forth in paragraphs
260-10-45-60 through 45-70.
The weighted-average shares of common stock outstanding should exclude shares of common stock that will be repurchased under a forward contract that requires an entity to repurchase a fixed number of its shares of common stock. Such shares of common stock should be removed from the shares of common stock outstanding beginning on the date the forward contract is entered into.
Questions often arise about whether it is appropriate to
reduce the denominator in the calculation of basic EPS when an entity has a
forward contract to repurchase a variable number of shares that must be
physically settled. Although the EPS guidance in ASC 480-10-45-4 refers to
contracts in which a fixed number of shares must be physically settled, it
is generally appropriate to reduce the denominator by the minimum number of
shares of common stock that will be repurchased, but only if the contract
specifies a contractual minimum. In these circumstances, the entity should
apply a method akin to the two-class method for the number of shares removed
from the denominator if those shares are entitled to dividends during the
period of the forward contract and the holder is not obligated to return
those dividends to the entity. See Section 3.2.4.3.1 for further
discussion of the adjustments to the numerator for the shares of common
stock removed from the denominator.
3.3.4 Shareholder Distributions
In certain situations, the outstanding number of shares of common stock must be adjusted retrospectively for all prior periods presented. These situations include:
- Stock dividends and stock splits (including reverse stock splits) — see Section 8.2.1.
- Rights issues — see Section 8.2.2.
- Nominal issuances of common stock — see Section 8.3.4.
Other distributions to shareholders are considered the issuance of common stock and do not need to be treated retrospectively. Rather, in such cases, the shares of common stock are considered outstanding and included in the denominator of the calculation of basic EPS only from the issuance date. See further discussion in Section 8.3.3.
3.3.5 Business Combinations and Reorganizations
ASC 260 does not permit the retrospective adjustment of EPS for shares of common stock issued in a business combination. Rather, such shares issued as part of the purchase price affect the weighted-average common shares outstanding in the calculation of basic EPS only from the issuance date. However, in reverse merger transactions and certain reorganizations that are considered akin to split-like situations, the number of shares of common stock is retrospectively adjusted to the earliest period presented to reflect the recapitalization. See discussion of these types of situations, as well as the impact of spin-off transactions, in Section 8.6.
3.4 Example
As discussed above, basic EPS is calculated by first determining income
available to common stockholders, which takes into account dividends declared and
accumulated for preferred stock, among other adjustments to net income. Income
available to common stockholders (numerator) is then divided by the weighted-average
number of common shares outstanding (denominator). Dilutive securities are not
considered outstanding common stock for basic EPS. If there are contingently
issuable shares (shares issuable for little or no cash consideration upon the
satisfaction of certain conditions in accordance with a contingent stock agreement),
they are considered outstanding common stock in the calculation of basic EPS when
issuance is no longer contingent. The example below illustrates the first-quarter
calculation of basic EPS for an entity with a complex capital structure.
Example 3-32
Basic EPS for Entity With Complex Capital Structure
Assume the following facts:
- Company A has 20,000, $1,000 par value, 6 percent shares of convertible preferred stock outstanding for the entire period. The preferred stock does not participate in earnings with common shareholders.
- Income from continuing operations and net income for the first quarter ended March 31, 20X1, was $4 million.
- Company A had 4 million shares of common stock outstanding on January 1, 20X1.
- On March 1, 20X1, A issued 500,000 shares of common stock in a secondary offering, and on March 15, 20X1, options on 50,000 shares of common stock were exercised by employees.
- Employees hold options on 200,000 additional shares of common stock that vest and become exercisable over the next three to seven years. These options are not considered participating securities.
On the basis of the facts, the calculation of income available to common stockholders for the first quarter ended March 31, 20X1, is as follows:
The weighted-average shares of common stock outstanding during the first quarter ended March 31, 20X1, are calculated as follows:
Basic EPS for the first quarter ended March 31, 20X1, is calculated as follows:
The calculation of basic EPS is not affected by either the conversion option in the preferred stock or the unexercised employee stock options because neither security is considered a participating security. However, both would affect the denominator in the calculation of diluted EPS. For an example illustrating the calculation of basic EPS under the two-class method, see Chapter 5.
Chapter 4 — Diluted EPS
Chapter 4 — Diluted EPS
4.1 Background
ASC 260-10
Diluted EPS
10-2 The objective of diluted EPS is consistent with that of basic EPS — to measure the performance of an entity over the reporting period — while giving effect to all dilutive potential common shares that were outstanding during the period.
Computation of Diluted EPS
45-16 The computation of diluted EPS is similar to the
computation of basic EPS except that the denominator is increased to include the
number of additional common shares that would have been outstanding if the
dilutive potential common shares had been issued. In computing the dilutive
effect of convertible securities, the numerator is adjusted in accordance with
the guidance in paragraph 260-10-45-40. Adjustments also may be necessary for
certain contracts that provide the issuer or holder with a choice between
settlement methods. See Example 1 (paragraph 260-10-55-38) for an illustration
of this guidance.
As noted above, diluted EPS is a per-share performance measure that includes (1)
outstanding common shares and (2) “additional common shares that would have been outstanding
if the dilutive potential common shares had been issued.” In calculating diluted EPS, an
entity assumes that all dilutive potential common shares within its capital structure were
outstanding during the reporting period and that net income (the numerator) was calculated
by using a consistent assumption. The complexity of calculating diluted EPS will vary
depending on the nature of an entity’s capital structure.
The graphic below illustrates the most common types of contractual arrangements that may involve potential common shares. See Table 4-1 for a summary of the methods applied to various types of contracts to determine the dilutive impact on EPS.
In calculating diluted EPS, an entity leverages the calculation of basic EPS.
Specifically, an entity calculates diluted EPS by making various adjustments to the
numerator and denominator in the calculation of basic EPS to reflect the impact of potential
common shares. To do so, the entity uses one of four methods — the treasury stock method,
the reverse treasury stock method, the if-converted method, or the contingently issuable
share method. The calculation of diluted EPS may also need to reflect adjustments to the
numerator for convertible instruments and contracts whose accounting classification differs
from their EPS treatment (e.g., contracts classified as assets or liabilities that are
considered share-settled for diluted EPS purposes). Entities with more complex capital
structures may also need to apply the two-class method in calculating diluted EPS. The
graphic below illustrates the types of adjustments to the numerator and denominator that an
entity may be required to make when calculating diluted EPS.
As discussed in Chapter
2, diluted EPS must be presented or disclosed any time basic EPS is presented
or disclosed. For entities that have multiple classes of common stock, diluted EPS must be
presented on the face of the income statement for each class of common stock. As discussed
in Section 8.7.1, if an entity
reports a discontinued operation, it must present diluted EPS from continuing operations and
net income on the face of the income statement and must present on the face of the income
statement, or disclose in the notes, diluted EPS for discontinued operations. For entities
with NCIs, diluted EPS is calculated on the basis of income attributable to the parent
(i.e., income attributable to NCIs is excluded from the calculation of diluted EPS). See
further discussion in Sections
8.7.2 and 8.8.
The discussion in this chapter is generally in the context of an entity
that presents only one amount of diluted EPS (i.e., the entity does not have any
discontinued operations). Unless otherwise noted, in this chapter, “net income” encompasses
both net income and net loss and refers to consolidated net income for an entity that does
not have an NCI and income attributable to the parent for an entity with an NCI. “Income
available to common stockholders,” which is defined in ASC 260-10-20, refers to income
available or loss attributable to common stockholders for an entity that does not have an
NCI and income available or loss attributable to common stockholders of the parent for an
entity that has an NCI. While an entity with a discontinued operation may have one or more
of income from continuing operations, loss from continuing operations, income from
discontinued operations, loss from discontinued operations, net income, or net loss,
references to “income” or “net income” in this chapter also encompass “loss” and “net loss,”
respectively.
The discussion in Sections 4.2 through 4.8 is based on an entity’s calculation of diluted EPS during a
discrete reporting period (i.e., a quarterly financial reporting period for an SEC registrant). Section 4.9
addresses special considerations related to calculating diluted EPS on a year-to-date basis.
This chapter does not discuss the application of the two-class method of calculating diluted EPS. For
discussion of that method, see Chapter 5.
4.1.1 Methods of Calculating Diluted EPS
The table below lists the different types of contracts to which an entity
generally applies the various methods of calculating diluted EPS.
Table 4-1
Type of Potential Common Share | Diluted EPS Method(s) Applicable | Section in This Chapter |
---|---|---|
Written call options (common stock) | Treasury stock | |
Written put options (common stock) | Reverse treasury stock | |
Nonvested shares (common stock) | Treasury stock | |
Forward sale contracts (common stock) | Treasury stock | |
Forward purchase contracts (common stock) | Reverse treasury stock | |
Convertible debt | If-converted | |
Convertible preferred stock | If-converted | |
Written call options (convertible securities) | Treasury stock | |
Forward sale contracts (convertible securities) | Treasury stock | |
Contingently issuable shares | Contingently issuable share |
4.1.1.1 Purchased Options
ASC 260-10
Purchased Options
45-37 Contracts such as purchased put options and
purchased call options (options held by the entity on its own stock) shall
not be included in the computation of diluted EPS because including them
would be antidilutive. That is, the put option would be exercised only when
the exercise price is higher than the market price and the call option would
be exercised only when the exercise price is lower than the market price; in
both instances, the effect would be antidilutive under both the treasury
stock method and the reverse treasury stock method, respectively.
Contracts that give an entity the right to either purchase or sell its common stock are never included in the calculation of diluted EPS because they would only be exercised by the entity when they are in-the-money and the resulting effect would be antidilutive under the treasury stock method or the reverse treasury stock method. Purchased options should not be included in the calculation of diluted EPS under the treasury stock method or reverse treasury stock method regardless of whether (1) the control number for calculating diluted EPS is income or a loss or (2) the purchased options are classified as an asset or within stockholders’ equity. If an entity has recognized a purchased option on its common stock as an asset at fair value, with changes in fair value recognized in earnings, the entity should not reverse the fair value adjustments recognized in earnings on the asset that have been included in the numerator in the calculation of diluted EPS.
Connecting the Dots
An entity may enter into a combination of purchased and written options on its
common stock in an attempt to economically hedge share dilution. Such strategies
commonly occur in conjunction with the issuance of convertible securities (e.g.,
capped call and other call spread transactions). ASC 260 does not allow an entity to
offset the dilutive effect of outstanding written options with purchased options
even if the options are with the same counterparty. Therefore, when an entity has
entered into both purchased and written options on its common stock, the accounting
for diluted EPS depends on the unit of account for such options. (For further
discussion of the identification of units of account, see Section 3.3.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.)
If an entity concludes that the purchased option and written option components are
separate freestanding financial instruments, the treasury stock or reverse treasury
stock method, as applicable, must be applied to the written option, with no
adjustments in the calculation of diluted EPS made for the purchased option. If,
however, an entity concludes that a combination of purchased and written options
constitutes a single unit of account, the entity should apply the treasury stock
method or reverse stock method, as applicable, to the combined contract provided
that it is dilutive to do so (i.e., the written option element is in-the-money from
the perspective of the counterparty). In this situation, the effect of the purchased
option component of the single combined freestanding financial instrument may
partially offset the dilutive impact of the written option component of the single
combined freestanding financial instrument. Regardless of the unit of account, the
entity should also consider whether purchased or written option contracts, or
combinations thereof, represent participating securities to which it must apply the
two-class method of calculating diluted EPS.
4.1.2 Antidilution and Control Number
4.1.2.1 General
ASC 260-10
No Antidilution
45-17 The computation of diluted EPS shall not
assume conversion, exercise, or contingent issuance of securities that would
have an antidilutive effect on EPS. Shares issued on actual conversion,
exercise, or satisfaction of certain conditions for which the underlying
potential common shares were antidilutive shall be included in the
computation as outstanding common shares from the date of conversion,
exercise, or satisfaction of those conditions, respectively. In determining
whether potential common shares are dilutive or antidilutive, each issue or
series of issues of potential common shares shall be considered separately
rather than in the aggregate.
45-18 Convertible securities may be dilutive on their own but antidilutive when included with other potential
common shares in computing diluted EPS. To reflect maximum potential dilution, each issue or series of
issues of potential common shares shall be considered in sequence from the most dilutive to the least dilutive.
That is, dilutive potential common shares with the lowest earnings per incremental share shall be included
in diluted EPS before those with a higher earnings per incremental share. Example 4 (see paragraph 260-10-55-57) illustrates that provision. Options and warrants generally will be included first because use of the
treasury stock method does not affect the numerator of the computation. An entity that reports a discontinued
operation in a period shall use income from continuing operations (adjusted for preferred dividends as
described in paragraph 260-10-45-11) as the control number in determining whether those potential common
shares are dilutive or antidilutive. That is, the same number of potential common shares used in computing the
diluted per-share amount for income from continuing operations shall be used in computing all other reported
diluted per-share amounts even if those amounts will be antidilutive to their respective basic per-share
amounts. (See paragraph 260-10-45-3.) The control number excludes income from continuing operations
attributable to the noncontrolling interest in a subsidiary in accordance with paragraph 260-10-45-11A.
Example 14 (see paragraph 260-10-55-90) provides an illustration of this guidance.
45-19 Including potential common shares in the denominator of a diluted per-share computation for continuing operations always will result in an antidilutive per-share amount when an entity has a loss from continuing operations or a loss from continuing operations available to common stockholders (that is, after any preferred dividend deductions). Although including those potential common shares in the other diluted per-share computations may be dilutive to their comparable basic per-share amounts, no potential common shares shall be included in the computation of any diluted per-share amount when a loss from continuing operations exists, even if the entity reports net income.
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.
Only potential common shares that are dilutive (i.e., that reduce basic EPS) are included in the calculation of diluted EPS. ASC 260-10-45-17 through 45-20 illustrate two important concepts that an entity must consider in determining whether potential common shares are dilutive — the control number and antidilution sequencing. The application of these concepts in the calculation of diluted EPS for a discrete financial reporting period is discussed below. Section 4.9 discusses the application of these concepts to a year-to-date calculation of diluted EPS.
4.1.2.2 Control Number
The control number represents the single amount that an entity uses to determine
whether each potential common share issuance or series of issuances is dilutive. The
control number is applied, along with the antidilution sequencing requirements, to
calculate diluted EPS (see Section
4.1.2.3 for discussion of antidilution sequencing). The control number
simplifies the calculation of diluted EPS for an entity that presents a discontinued
operation because the entity includes the same potential common shares in the
calculation of diluted EPS for continuing operations, discontinued operations, and net
income. When an entity reports a discontinued operation, it uses income from continuing
operations as the control number and applies the antidilution sequencing requirements to
potential common shares to determine whether they are included in diluted EPS from
continuing operations. If so, the entity always includes those potential common shares
in the amounts of diluted EPS calculated for discontinued operations and net income,
even if such inclusion is antidilutive to those respective amounts of diluted EPS. The
table below summarizes the control number that is used to determine whether potential
common shares are included in the calculation of diluted EPS in accordance with the
antidilution sequencing requirements of ASC 260.
Table 4-2
Income Statement Contains
|
Control Number
|
Reporting If Control Number Is a Loss1
|
---|---|---|
No discontinued operations or NCIs
|
Income available to common stockholders2
|
The inclusion of potential common shares in diluted EPS
will always be antidilutive. Therefore, basic EPS and diluted EPS are the
same.
|
Discontinued operations only
|
Income available to common stockholders from continuing
operations3
|
The inclusion of potential common shares in diluted EPS
related to continuing operations will always be antidilutive. Therefore,
basic EPS and diluted EPS are the same for continuing operations,
discontinued operations, and net income even if an entity reports income
from continuing operations, income from discontinued operations, or net
income.
|
NCIs only
|
Income available to common stockholders of the parent4
|
The inclusion of potential common shares in diluted EPS
will always be antidilutive. Therefore, basic EPS and diluted EPS are the
same.
|
Discontinued operations and NCIs
|
Income available to common stockholders of the parent from
continuing operations5
|
The inclusion of potential common shares in diluted EPS
from continuing operations will always be antidilutive. Therefore, basic EPS
and diluted EPS are the same for continuing operations, discontinued
operations, and net income attributable to the parent even if the entity
reports income from continuing operations, income from discontinued
operations, or net income.
|
As discussed in the table above, when an entity reports a discontinued
operation, income from continuing operations is the control number used to determine
whether potential common shares are included in the calculation of diluted EPS in
accordance with the antidilution sequencing requirements of ASC 260. As a result, if an
entity reports a loss from continuing operations, all potential common shares will always be excluded from the calculations of diluted EPS from
continuing operations, discontinued operations, and net income regardless of whether
there is income or loss from discontinued operations and net income. Conversely, if an
entity reports income from continuing operations, all potential common shares that are
dilutive to income from continuing operations in accordance with the antidilution
sequencing requirements of ASC 260 will always be included in
the calculations of diluted EPS from continuing operations, discontinued operations, and
net income regardless of whether there is income or loss from discontinued operations
and net income. Thus, potential common shares that are dilutive to discontinued
operations will be excluded from diluted EPS from discontinued operations when those
potential common shares are antidilutive to continuing operations. Similarly, potential
common shares that are antidilutive to discontinued operations will be included in
diluted EPS from discontinued operations when those potential common shares are dilutive
to continuing operations. Because of this requirement, it is possible for diluted EPS to
be a smaller loss per share than the loss per share for basic EPS for discontinued
operations and net income when losses are reported for those items but income is
reported from continuing operations. Example 14 in ASC 260-10-55-90 and 55-91
illustrates how the control number concept can result in a diluted loss per share from
discontinued operations and net income that is less than the corresponding amounts of
basic loss per share.
ASC 260-10
Example 14: Antidilutive Securities
55-90 This Example illustrates the guidance in paragraph 260-10-45-18.
55-91 Assume that Entity A has income from continuing operations of $2,400, a loss from discontinued operations of $(3,600), a net loss of $(1,200), and 1,000 common shares and 200 potential common shares outstanding. Entity A’s basic per-share amounts would be $2.40 for continuing operations, $(3.60) for the discontinued operation, and $(1.20) for the net loss. Entity A would include the 200 potential common shares in the denominator of its diluted per-share computation for continuing operations because the resulting $2.00 per share is dilutive. (For illustrative purposes, assume no numerator impact of those 200 potential common shares.) Because income from continuing operations is the control number, Entity A also must include those 200 potential common shares in the denominator for the other per-share amounts, even though the resulting per-share amounts [$(3.00) per share for the loss from discontinued operation and $(1.00) per share for the net loss] are antidilutive to their comparable basic per-share amounts; that is, the loss per-share amounts are less.
4.1.2.3 Antidilution Sequencing
An entity is prohibited from applying antidilution (i.e., increasing basic EPS
for the control number) in calculating diluted EPS. Accordingly, an entity must
calculate diluted EPS in a manner that maximizes dilution (i.e., the amount of diluted
EPS calculated is the lowest possible amount based on all potential combinations of the
dilutive impact of potential common shares). To achieve this result, an entity must
“sequence” each issuance or series of issuance of potential common shares that are
individually dilutive in the order from most dilutive to least dilutive.6 Once these share issuances are sequenced, the entity includes the dilutive effect
of each potential common share in the calculation of diluted EPS until the inclusion of
the individually dilutive effect of a potential common share is antidilutive to the
overall calculation of diluted EPS. When this occurs, that potential common share, as
well as all other potential common shares that are less dilutive, is excluded from the
calculation of diluted EPS.
Antidilution sequencing is applied only to the control number. Thus, as stated above, when an entity has
a discontinued operation, the same potential common shares included in diluted EPS from continuing
operations are included in the calculations of diluted EPS for discontinued operations and net income.
Antidilution sequencing is required in the calculation of diluted EPS unless (1) the control number is a
loss (i.e., all potential common shares would be antidilutive) or (2) the entity has only one issuance of
potential common shares.
Connecting the Dots
When an entity has multiple issuances of the same potential common share, it generally must
consider each issuance separately in applying antidilution sequencing. Issuances of multiple
instruments may be aggregated and considered a single issuance for sequencing
purposes during a financial reporting period only if all the following conditions are met:
- The instruments are of the same type and have all the same terms (i.e., they are identical).
- The instruments were outstanding for the same days during the financial reporting period (i.e., they either were outstanding for the entire period or issued or expired on the same day during the financial reporting period).
Aggregation of multiple instruments into a single issuance for antidilution
sequencing purposes is only appropriate when each individual instrument has the same incremental
dilutive effect. Since the average market price that is used under the treasury stock method
is affected by the number of days a potential common share is outstanding during a financial
reporting period, it would not be appropriate to aggregate instruments with the same terms that
were not outstanding for the same number of days during a financial reporting period.
Example 4 in ASC 260-10-55-57 through 55-59 illustrates the concept of antidilution sequencing.
ASC 260-10
Example 4: Antidilution Sequencing
55-57 This Example illustrates the antidilution sequencing provisions described in paragraph 260-10-45-18 for Entity A for the year ended December 31, 20X0. This Example has the following assumptions:
- Entity A had income available to common stockholders of $10,000,000 for the year 20X0.
- 2,000,000 shares of common stock were outstanding for the entire year 20X0.
- The average market price of the common stock was $75.
- Entity A had the following potential common shares outstanding during the year:
- Options (not compensation-related) to buy 100,000 shares of common stock at $60 per share.
- 800,000 shares of convertible preferred stock entitled to a cumulative dividend of $8 per share. Each preferred share is convertible into two shares of common stock.
- 5 percent convertible debentures with a principal amount of $100,000,000 (issued at par). Each $1,000 debenture is convertible into 20 shares of common stock.
- The tax rate was 40 percent for 20X0.
55-58 The following table illustrates calculation of earnings per incremental share.
55-59 The following table illustrates calculation of diluted EPS.
Footnotes
1
The control number may be a loss when an entity
reports net income because it includes the impact of dividends on
preferred stock.
2
Income available to common stockholders generally
represents net income less preferred stock dividends. As discussed in
Chapter
3, many types of transactions represent “deemed” preferred
stock dividends that reduce net income in arriving at income available
to common stockholders.
3
Income available to common stockholders from
continuing operations generally represents income from continuing
operations less preferred stock dividends allocated to continuing
operations. As discussed in Chapter 3, many types of
transactions can result in adjustments to net income in arriving at
income available to common stockholders. When an entity presents a
discontinued operation, adjustments to net income to arrive at income
available to common stockholders must be allocated between continuing
and discontinued operations to arrive at income available to common
stockholders from continuing operations. Sections 8.6.3.2.1 and 8.7 further discuss
the accounting and presentation of EPS for an entity that presents a
discontinued operation.
4
Income available to common stockholders of the parent
generally represents net income attributable to the parent less
preferred stock dividends allocated to the parent. As discussed in
Chapter
3, many types of transactions can result in adjustments to
net income in arriving at income available to common stockholders. When
an entity presents an NCI, adjustments to income attributable to the
parent to arrive at income available to common stockholders of the
parent are determined by including the parent’s portion of income
available to common stockholders of the consolidated subsidiary in the
parent’s calculation of income available to common stockholders. See
Section
8.8 for further discussion of how EPS is calculated for an
entity with an NCI.
5
Income available to common stockholders of the parent
from continuing operations represents income attributable to the parent
from continuing operations less preferred stock dividends. As discussed
in Chapter
3, many types of transactions can result in adjustments to
net income in arriving at income available to common stockholders. When
an entity presents a discontinued operation and an NCI, the
considerations discussed in notes 3 and 4 of this table are relevant.
Example
8-19 illustrates the presentation of EPS for an entity that
reports an NCI in a discontinued operation.
6
Any potential common share that is individually antidilutive is
excluded from the antidilution sequencing process. For example, as discussed in
Section 4.2.2.1,
under the treasury stock method, options on common shares that are out-of-the-money
are individually antidilutive and would never be included in diluted EPS regardless
of the control number.
4.2 Treasury Stock Method
4.2.1 Scope
ASC 260-10
Options, Warrants, and Their Equivalents and the Treasury
Stock Method
45-22 The dilutive effect of
outstanding call options and warrants (and their
equivalents) issued by the reporting entity shall be
reflected in diluted EPS by application of the treasury
stock method unless the provisions of paragraphs
260-10-45-35 through 45-36 and 260-10-55-8 through 55-11
require that another method be applied. Equivalents of
options and warrants include nonvested stock granted under a
share-based payment arrangement, stock purchase contracts,
and partially paid stock subscriptions (see paragraph
260-10-55-23). Antidilutive contracts, such as purchased put
options and purchased call options, shall be excluded from
diluted EPS.
The treasury stock method applies to the following types of potential common
shares if they are dilutive7 (except in certain circumstances, discussed below):
-
Written call options (common stock) — Options and warrants written by an entity under which the counterparty has the right, but not the obligation, to purchase a specified quantity or amount of common stock at a fixed or otherwise determinable price, including those issued in share-based payment arrangements.8 These written call options are also called “warrants.”
-
Written call options (convertible securities) — Options and warrants written by an entity under which the counterparty has the right, but not the obligation, to purchase a specified quantity or amount of the entity’s convertible securities at a fixed or otherwise determinable price, including those issued in share-based payment arrangements. These written call options are also called “warrants on convertible securities.”
-
Forward sale contracts (common stock) — Contracts that require the entity to sell a specified quantity or amount of common stock to the counterparty at a fixed or otherwise determinable price.
-
Forward sale contracts (convertible securities) — Contracts that require the entity to sell a specified quantity or amount of convertible securities to the counterparty at a fixed or otherwise determinable price.
-
Nonvested shares (common stock) — Agreements between an entity and an employee or nonemployee in a share-based payment arrangement to issue common shares, provided that the counterparty meets a relevant vesting condition (i.e., a service, performance, or market condition).
An entity should not apply the treasury stock method to a contract listed above
in the following situations:
-
The contract must be net settled in cash (i.e., no common shares or potential common shares are issued upon settlement).
-
The contract is a participating security and the two-class method of calculating diluted EPS is more dilutive than the treasury stock method.
The discussion in the next section focuses on the application of the treasury
stock method to potential common shares within its scope that are not participating
securities. If a potential common share is a participating security, an entity is
required to use the more dilutive of the treasury stock method or the two-class
method of calculating diluted EPS (see Section 5.5.4). Sections 4.2.2.3.4 and 4.6 discuss the application
of the treasury stock method to instruments that contain multiple settlement
alternatives. Section
7.1.2.1 provides additional guidance on applying the treasury stock
method to potential common shares issued in a share-based payment arrangement.
4.2.2 Application of the Treasury Stock Method
4.2.2.1 Contracts to Sell Common Stock
ASC 260-10
Conversion Rate or Exercise Price
45-21 Diluted EPS shall be
based on the most advantageous conversion rate or
exercise price from the standpoint of the security
holder. Previously reported diluted EPS data shall not
be retroactively adjusted for subsequent conversions or
subsequent changes in the market price of the common
stock.
Variable
Denominator
45-21A Changes in an entity’s
share price may affect the exercise price of a financial
instrument or the number of shares that would be used to
settle the financial instrument. For example, when the
principal of a convertible debt instrument is required
to be settled in cash but the conversion premium is
required to (or may) be settled in shares, the number of
shares to be included in the diluted EPS denominator is
affected by the entity’s share price. In applying both
the treasury stock method and the if-converted method of
calculating diluted EPS, the average market price shall
be used for purposes of calculating the denominator for
diluted EPS when the number of shares that may be issued
is variable, except for contingently issuable shares
within the scope of the guidance in paragraphs
260-10-45-48 through 45-57. See paragraphs 260-10-55-4
through 55-5 for implementation guidance on determining
an average market price.
Options, Warrants, and Their Equivalents and the Treasury Stock Method
Under the treasury stock method:
- Exercise of options and warrants shall be assumed at the beginning of the period (or at time of issuance, if later) and common shares shall be assumed to be issued.
- The proceeds from exercise shall be assumed to be used to purchase common stock at the average market price during the period. (See paragraphs 260-10-45-29 and 260-10-55-4 through 55-5.)
- The incremental shares (the difference between the number of shares assumed issued and the number of shares assumed purchased) shall be included in the denominator of the diluted EPS computation.
Example 15 (see paragraph 260-10-55-92)
provides an illustration of this guidance. See paragraph
260-10-45-21A if the exercise price of a financial
instrument or the number of shares that would be used to
settle the financial instrument is variable.
45-25 Options and warrants will have a dilutive effect under the treasury stock method only when the average
market price of the common stock during the period exceeds the exercise price of the options or warrants
(they are in the money). Previously reported EPS data shall not be retroactively adjusted as a result of changes
in market prices of common stock.
45-26 Dilutive options or warrants that are issued during a period or that expire or are cancelled during a
period shall be included in the denominator of diluted EPS for the period that they were outstanding. Likewise,
dilutive options or warrants exercised during the period shall be included in the denominator for the period
prior to actual exercise. The common shares issued upon exercise of options or warrants shall be included in
the denominator for the period after the exercise date. Consequently, incremental shares assumed issued shall
be weighted for the period the options or warrants were outstanding, and common shares actually issued
shall be weighted for the period the shares were outstanding.
45-27 Paragraphs 260-10-55-3 through 55-11 provide additional guidance on the application of the treasury
stock method.
Share-Based Payment Arrangements
45-28 The provisions in
paragraphs 260-10-45-28A through 45-31 apply to
share-based awards issued to grantees under a
share-based payment arrangement in exchange for goods
and services or as consideration payable to a
customer.
45-28A Awards of share
options and nonvested shares (as defined in Topic 718)
to be issued to a grantee under a share-based payment
arrangement are considered options for purposes of
computing diluted EPS. Such share-based awards shall be
considered to be outstanding as of the grant date for
purposes of computing diluted EPS even though their
exercise may be contingent upon vesting. Those
share-based awards are included in the diluted EPS
computation even if the grantee may not receive (or be
able to sell) the stock until some future date.
Accordingly, all shares to be issued shall be included
in computing diluted EPS if the effect is dilutive. The
dilutive effect of share-based payment arrangements
shall be computed using the treasury stock method. If
the equity share options or other equity instruments are
outstanding for only part of a period, the shares
issuable shall be weighted to reflect the portion of the
period during which the equity instruments were
outstanding. See Example 8 (paragraph 260-10-55-68).
45-28B In applying the treasury stock method, all dilutive potential common shares, regardless of whether they are exercisable, are treated as if they had been exercised. The treasury stock method assumes that the proceeds upon exercise are used to repurchase the entity’s stock, reducing the number of shares to be added to outstanding common stock in computing EPS.
45-29 In applying the
treasury stock method described in paragraph
260-10-45-23, the assumed proceeds shall be the sum of
both of the following:
-
The amount, if any, the grantee must pay upon exercise.
-
The amount of cost attributed to share-based payment awards (within the scope of Topic 718 on stock compensation) not yet recognized. This amount includes share-based payment awards that are not contingent upon satisfying certain conditions as described in paragraph 260-10-45-32 and contingently issuable shares that have been determined to be included in the computation of diluted EPS as described in paragraphs 260-10-45-48 through 45-57
-
Subparagraph superseded by Accounting Standards Update No. 2016-09.
45-29A Under paragraphs
718-10-35-1D and 718-10-35-3, the effect of forfeitures
is taken into account by recognizing compensation cost
for those instruments for which the employee’s requisite
service has been rendered or the nonemployee’s vesting
conditions have been met and no compensation cost shall
be recognized for instruments that grantees forfeit
because a service or performance condition is not
satisfied. See Example 8 (paragraph 260-10-55-68) for an
illustration of this guidance.
45-32 Fixed grantee stock
options (fixed awards) and nonvested stock (including
restricted stock) shall be included in the computation
of diluted EPS based on the provisions for options and
warrants in paragraphs 260-10-45-22 through 45-27. Even
though their issuance may be contingent upon vesting,
they shall not be considered to be contingently issuable
shares (see Section 815-15-55 and paragraph
260-10-45-48). However, because issuance of
performance-based stock options (and performance-based
nonvested stock) is contingent upon satisfying
conditions in addition to the mere passage of time,
those options and nonvested stock shall be considered to
be contingently issuable shares in the computation of
diluted EPS. A distinction shall be made only between
time-related contingencies and contingencies requiring
specific achievement.
The treasury stock method represents a method for determining the dilutive
effect of options, warrants, nonvested shares, forward sale contracts, and
similar instruments. Under this method, it is assumed that the proceeds that
would be received upon settlement are used to repurchase common shares at the
average market price during the period. ASC 260-10-45-23 through 45-32 describe
how the treasury stock method is applied and include specific discussion of its
application to share-based payment arrangements.
The treasury stock method is only applied to options and warrants that are
in-the-money from the perspective of the counterparty. It is not applied to
options and warrants that are out-of-the-money from the counterparty’s
perspective, because (1) the holder would not elect to exercise an instrument
that is not in-the-money and (2) application of the treasury stock method would
generally be antidilutive. The determination of whether an option or warrant is
in-the-money is made by comparing the average market price of the common stock
during the period with the assumed proceeds received upon exercise of the
instrument. For share-based payment awards, the proceeds include the exercise
price and the average amount of cost not yet recognized. For all other
instruments, the proceeds are limited to the exercise price. See Section 7.1.2.1 for
additional discussion of the application of the treasury stock method to
share-based payment awards.
An entity must determine whether options or warrants are in-the-money, and must
apply the treasury stock method, on an instrument-by-instrument basis. If the
average market price of common stock during the period exceeds the proceeds per
common share issuable, an option or warrant is in-the-money. In determining
whether an option or warrant is in-the-money, it is not appropriate for an
entity to compare the end-of-period market price of the common stock with the
proceeds. Further, in making this determination, as well as in applying the
treasury stock method, an entity must consider the guidance in ASC 260-10-45-21,
which states that diluted EPS is calculated on the basis of “the most
advantageous conversion rate or exercise price from the standpoint of the
security holder.” This would include any exercise price available to the holder
at some future date that results from the mere passage of time (see further
discussion in Section
4.2.2.1.2.1). Sections
4.2.2.1.1 and 4.2.2.1.2
discuss considerations related to situations in which the number of shares or
proceeds received upon exercise varies.
Connecting the Dots
An entity may classify options and warrants as liabilities and measure them at
fair value, with changes in fair value recognized in earnings. When the
treasury stock method is applied for diluted EPS purposes, the numerator
must be adjusted because, under the treasury stock method, the
instrument is assumed to be classified within equity (and the income
statement effect of the contract would not have occurred had it been
exchanged for common shares at the beginning of the period or on the
date of issuance, if later). As discussed in Sections 4.2.2.3 and 4.7.3, the
numerator adjustment reflects a reversal of the mark-to-market
adjustment that was recognized on the option or warrant during the
period, net of tax. The aggregate effect of this adjustment to the
numerator and the incremental common shares included in the denominator
could potentially yield a dilutive result during a reporting period even
though the option or warrant was out-of-the-money from the
counterparty’s perspective on the basis of a comparison of the (1)
proceeds per common share issuable with (2) average market price of the
entity’s common stock. Because the treasury stock method is not applied
to options or warrants that are out-of-the-money, an entity should not
include the dilutive result that would occur if the mark-to-market
reversal was made to the numerator and the shares were added to the
denominator.
In addition, the adjustment to the numerator and application of the treasury stock method to liability-classified options or warrants could potentially yield an antidilutive result during a financial reporting period even if the option or warrant was in-the-money from the counterparty’s perspective on the basis of a comparison of the (1) proceeds per common share issuable with (2) average market price of the entity’s common stock. Because an entity, in considering the antidilution sequencing requirements of ASC 260, does not apply the treasury stock method when options or warrants are antidilutive, the entity should not include the antidilutive result that would occur if the mark-to-market reversal was made to the numerator and the share adjustments were made to the denominator, even though the instrument was in-the-money from the counterparty’s perspective.
Nonvested shares of common stock are issued to employees and nonemployees in
share-based payment arrangements. Because there is no exercise price for
nonvested shares issued in a share-based payment arrangement, the treasury stock
method is generally dilutive. However, the average cost not yet recognized for
financial reporting purposes (which is considered proceeds) may possibly
purchase more than the number of nonvested shares at the average market price
during a financial reporting period.
Forward contracts to sell common stock must be settled regardless of whether
they are in-the-money or out-of-the-money from the counterparty’s perspective;
therefore, the treasury stock method always applies to forward sale contracts if
they are dilutive. The determination of whether a forward sale contract is
dilutive under the antidilution sequencing guidance in ASC 260 is made on an
instrument-by-instrument basis. Forward sale contracts may be dilutive to EPS
even if they are out-of-the-money from the counterparty’s perspective on the
basis of the end-of-period market price of the entity’s common stock because,
under the treasury stock method, it is assumed that there is a repurchase of
common shares at the average market price during the period. Thus, when the
entity considers the average market price of its common stock during the period,
the contract is in-the-money and dilutive under the treasury stock method.
In applying the treasury stock method to a forward sale contract, an entity must
consider the guidance in ASC 260-10-45-21, which states that diluted EPS is
calculated on the basis of “the most advantageous conversion rate or exercise
price from the standpoint of the security holder.” This would include any
forward price available to the holder at some future date that results from the
mere passage of time. See further discussion in Section 4.2.2.1.2.1. Sections 4.2.2.1.1 and 4.2.2.1.2 discuss considerations related to
situations in which the number of shares or proceeds received upon settlement
varies.
Connecting the Dots
As discussed above, options and warrants are subject to the treasury stock
method only if they are in-the-money on the basis of a comparison of the
proceeds on exercise with the average market price during the period,
whereas forward sale contracts are subject to the treasury stock method
in all cases if the result is dilutive. This distinction based on the
type of contract will not create any difference in the application of
the treasury stock method to a contract that is classified as an equity
instrument. This is because the treasury stock method will always be
antidilutive when applied to options, warrants, and forward sale
contracts that are out-of-the-money from the counterparty’s perspective
on the basis of a comparison of the per-share proceeds upon exercise or
settlement with the average market price of the entity’s common stock
during the period. This distinction based on the type of contract may,
however, create a difference between forward sale contracts and options
and warrants in the calculation of diluted EPS when the contract is
classified as an asset or liability because of the numerator adjustment
that is required in this circumstance.
4.2.2.1.1 Adjustments to the Number of Shares Issuable on Settlement
The number of common shares issuable upon settlement of options, warrants, nonvested shares,
forward sale contracts, and similar instruments may vary because of (1) the passage of time; (2) the
occurrence or nonoccurrence of a specified event; or (3) a specified rate, price, index, or other variable.
If the number of common shares issuable upon settlement varies on the basis of only the passage of time, an entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any settlement term that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty. See Example 4-1 for an illustration related to these concepts.
If the number of common shares issuable upon settlement is subject to adjustment
on the basis of the occurrence or nonoccurrence of a specified event (other
than changes in the fair value of the entity’s stock price) that is not
within the counterparty’s control, an entity should apply the guidance on
contingently issuable shares to determine the number of common shares
issuable upon settlement. As discussed in Section 4.5, the entity should assume
that the current status of the condition as of the reporting date will
remain unchanged (i.e., the specified event will not occur). As a result,
potential adjustment features that are commonly included in the terms of
instruments to sell common stock will have no impact on the application of
the treasury stock method until such adjustment events occur. The table
below lists common adjustment events that will have no impact on the
application of the treasury stock method before the occurrence of the
related event.
Table 4-3
Common Adjustment Features That Do Not Affect Calculations of Diluted EPS Until
the Adjustment Event Occurs |
---|
See Section 4.8.2 for discussion of the requirement to retrospectively adjust previously reported EPS amounts upon the occurrence of stock splits, reverse stock splits, stock dividends, and rights issues. |
If the number of common shares issuable upon settlement is linked to a specified
rate, price, index, or other variable, an entity should determine the number
of shares (see the table below) by applying either (1) the guidance in ASC
260-10-45-21A on variable denominators or (2) the guidance in ASC
260-10-45-48 through 45-57 on contingently issuable shares. Under the
variable denominator approach, the entity would determine the number of
common shares issuable upon settlement on the basis of the average of the
specified rate, price, index, or other variable during the reporting period.
As discussed in Section
4.5, under the contingently issuable share approach, the
entity would reflect the number of common shares that would be issued upon
settlement on the basis of the current rate, price, index, or other variable
at the end of the reporting period (or on the basis of the average rate,
price, index, or other variable, assuming settlement occurred on the last
day of the reporting period if the contract stipulates an average rate,
price, index, or other variable). As discussed in Section 4.2.2.1.3, under either
approach, the stock price used to calculate the number of common shares
assumed to be repurchased with the proceeds must reflect the average market
price during the entire financial reporting period (or portion thereof
during the reporting period the contract was outstanding). If the contract
is classified as an asset or liability, the numerator must also be adjusted
as part of the calculation under the treasury stock method, as discussed in
Section
4.2.2.3.1.
Table
4-4
Determining the Number of Shares
Issuable Upon Settlement When the Shares Vary on the
Basis of a Specified Rate, Price, Index, or Other
Variable
| ||
---|---|---|
Type of Variable
|
Approach Used
| |
Entity’s stock price
|
Average market price approach unless
the arrangement represents a contingently issuable
share9
| |
Other rate, price, index, or variable
|
Average market price approach or contingently
issuable share method
|
The average market price approach must be used if the number
of shares varies on the basis of just the entity’s stock price. However,
either the average market price approach or contingently issuable share
method can be applied, as a policy choice, if the variability is due to
something other than just the entity’s stock price, since ASC 260-10-45-21A
only specifically addresses how an entity should account for diluted EPS
when the variable is based only on the entity’s stock price.
See Example 4-3
for an illustration of how the treasury stock method is applied to a forward
contract to sell a variable number of common shares depending on the market
price of the entity’s common stock.
4.2.2.1.2 Proceeds
The determination of the proceeds used to apply the treasury stock method is
generally straightforward. The proceeds represent the amount the
counterparty must pay to receive the common shares underlying the contract
(i.e., the exercise price or forward price) and, for share-based payments,
include the average amount of compensation cost not yet recognized. However,
as discussed below, an entity must take additional considerations into
account in certain situations.
4.2.2.1.2.1 Adjustments to the Exercise Price or Forward Price
The exercise price or forward price of options, warrants, nonvested shares, forward sale contracts, and
similar instruments may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence of
a specified event; or (3) a specified rate, price, index, or other variable.
If the exercise price or forward price varies on the basis of only the passage of time, an entity should
apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the
most advantageous conversion rate or exercise price from the standpoint of the security holder.” The
entity must consider any exercise price or forward price that will be available to the counterparty at any
point during the term of the contract and assume settlement upon terms that maximize value to the
counterparty. See Examples 4-1 and 4-5 for illustrations related to these concepts.
If the exercise price or forward price is subject to adjustment on the basis of
the occurrence or nonoccurrence of a specified event (other than changes
in the fair value of the entity’s stock price) that is not within the
counterparty’s control, an entity should apply the guidance on
contingently issuable shares to determine the exercise price or forward
price. As discussed in Section 4.5, the entity should assume that the current
status of the condition as of the reporting date will remain unchanged
(i.e., the specified event will not occur). As a result, potential
adjustment features that are commonly included in the terms of
instruments to sell common stock will have no impact on the application
of the treasury stock method until such adjustments are made. Table 4-3
includes a list of common adjustment events that will have no impact on
the application of the treasury stock method before the occurrence of
the related event. See also Example 4-6.
If the exercise price or forward price varies solely on the basis of the
entity’s stock price, the entity should apply ASC 260-10-45-21A, which
requires that the entity determine the proceeds by using the average
market price of the entity’s stock during the reporting period. If,
however, the exercise price or forward price varies on the basis of a
specified rate, price, index, or other variable (i.e., it is not based
solely on the entity’s stock price), an entity may apply any of the
following approaches since ASC 260 does not contain specific guidance on
this matter:
-
View A: The proceeds reflect the exercise price or forward price as of the end of the reporting period — This view is consistent with the guidance in ASC 260 on contingently issuable shares. Although that guidance only specifically addresses how to determine the number of common shares, it may be applied by analogy to determine the exercise price or forward price. Under that guidance, it is assumed that the contingency (in this case, the amount of the exercise price or forward price) is resolved as of the end of the reporting period. Thus, an entity calculates the exercise price or forward price on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming settlement of the contract on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 for additional discussion of the contingently issuable share method.
-
View B: The proceeds reflect the lowest exercise price or forward price during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires that diluted EPS be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the exercise or forward prices applicable for the entire time during the reporting period in which the contract was outstanding and use the price that is least advantageous to the entity and produces the lowest proceeds. The entity should not project future exercise or forward prices since they will vary on the basis of changes in the rate, price, index, or other variable.
-
View C: The proceeds reflect the average exercise price or forward price during the reporting period — This view is consistent with ASC 260-10-45-21A and ASC 260-10-45-23, which require the use of an average.
These three approaches are acceptable regardless of whether the entity or
counterparty controls the timing of the settlement date (since neither
party ultimately controls the rate, price, index, or other variable that
affects the proceeds). The approach selected is considered an accounting
policy election that must be applied consistently and disclosed.
Under any of the three approaches described above, the entity must assume that
it repurchases common shares with the proceeds at the average market
price during the reporting period (see Section 4.2.2.1.3). In addition,
if the contract is classified as an asset or liability for accounting
purposes, which may be required because of the variable terms,10 the calculation of diluted EPS under the treasury stock method
should include an adjustment to the numerator, as discussed in Section
4.2.2.3.1. Example 4-4 illustrates the application of the
alternative views to a forward sale contract.
It is not acceptable to determine the proceeds on the basis of the exercise
price or forward price at the beginning of the reporting period because
there is no basis in ASC 260 for the use of this approach.
Connecting the Dots
It may be unclear whether an entity should apply
the guidance on contingently issuable shares in ASC 260-10-45-48
through 45-57 or the guidance on variable denominators in ASC
260-10-45-21A. In such cases, the entity must use judgment and
there could be diversity in practice. On the basis of informal
discussions with the FASB staff, we understand that the
amendments that ASU 2020-06 made to ASC 260 were not intended to
change an entity’s determination of whether the guidance on
contingently issuable shares applies. In those discussions, the
FASB staff acknowledged that the guidance in ASC 260 addressing
what constitutes a contingently issuable share is often
difficult to interpret in practice.
4.2.2.1.2.2 Prepaid Contracts
A prepaid forward sale contract is subject to the treasury stock method in the
calculation of diluted EPS. Since the counterparty has already paid the
forward price, there are no proceeds under the treasury stock method.
Because there are no proceeds, the dilution under the treasury stock
method is calculated as the number of common shares issuable under the
contract. If the number of common shares varies, an entity should apply
the guidance discussed in Section 4.2.2.1.1.
A counterparty to a stock option may prepay the exercise price before exercising
the stock option. For example, a stock option issued to an employee in a
share-based payment arrangement may be “early exercised” before the
award has vested. In this circumstance, the entity generally is required
or allowed to repurchase the stock option if it is ultimately not
exercised (or, for share-based payment awards, if it does not vest).
Because the counterparty has already paid cash to early exercise the
option, there is no cash that will be received from the counterparty in
the future. Further, the cash received could have been used to
repurchase shares during the requisite service period. As a result, the
cash received is not included in the computation of assumed proceeds. In
the absence of average unrecognized cost for share-based payment awards,
there will be no proceeds under the treasury stock method.
4.2.2.1.3 Average Market Price
ASC 260-10
Average Market Price
55-4 The average market price
of common stock shall represent a meaningful
average. Theoretically, every market transaction for
an entity’s common stock could be included in
determining the average market price. As a practical
matter, however, a simple average of weekly or
monthly prices usually will be adequate.
55-5 Generally, closing market prices are adequate for use in computing the average market price. When
prices fluctuate widely, however, an average of the high and low prices for the period that the price represents
usually would produce a more representative price. The method used to compute the average market price
shall be used consistently unless it is no longer representative because of changed conditions. For example, an
entity that uses closing market prices to compute the average market price for several years of relatively stable
market prices might need to change to an average of high and low prices if prices start fluctuating greatly and
the closing market prices no longer produce a representative average market price.
ASC 260-10-55-4 and 55-5 offer some flexibility related to an entity’s approach
to calculating average market prices when the entity applies the treasury
stock method. For entities whose common stock trades regularly, the most
precise method is generally to average daily closing stock prices.11 However, as discussed in ASC 260-10-55-4, a simple average of weekly
or even monthly common stock prices may be adequate in such circumstances.
If an entity decides to calculate an average common stock price by using a
basis other than an average of each day’s closing price, the entity should
ensure that the averaging method does not misrepresent the average market
price for the reporting period. The entity should apply the approach
selected consistently over time unless changes in facts and circumstances
result in the need to alter the approach used to calculate the average
market price.
Connecting the Dots
The common stock of many entities trades outside regular trading hours (also
referred to as “pre-market” or “after-hours” trading). In the United
States, the regular trading hours for equity securities are from
9:30 a.m. to 4:00 p.m. (ET). Any trading before 9:30 a.m. (ET) is
considered “pre-market” trading, and any trading after 4:00 p.m.
(ET) is considered “after-hours” trading. ASC 260 refers to the use
of closing stock prices, which represent the last published trade on
the relevant exchange (i.e., in the United States, the last trade
that occurs on or before 4:00 p.m. (ET)). Because the original
pronouncement that was codified in ASC 260 was issued before the
proliferation of pre-market and after-hours trading, ASC 260 does
not mention market prices occurring outside regular trading hours.
However, it is appropriate for entities not to include in the
average market price any trade that was completed before or after
regular trading hours. It may be appropriate for an entity to
consider trades in its common stock that occur outside regular
trading hours if trading in the entity’s common stock is limited,
but the entity must take care before considering such market prices.
In many cases, there is much less liquidity in pre-market and
after-hours trading, which may significantly affect the price of
trades. Furthermore, significant increases and decreases in the
market price of an entity’s common stock often occur in pre-market
or after-hours trading because of news released immediately before
or after the markets close. Because the volume of trades outside
regular trading hours is generally limited compared with trading
volume during regular trading hours, trading participants often
“over-react” more positively or negatively than they do when stock
prices occur during regular trading hours. As a result, in the
absence of a limited population of trades in an entity’s common
stock during regular trading hours, an entity should not include
market prices from trades that occur outside regular trading hours
in calculating the average market price during a period.
Additional considerations may be necessary when an entity’s common stock is thinly traded. It may be more appropriate to use a method other than an average of a limited population of trading prices. ASC 260-10-55-5 discusses the use of an average of the high and low prices for the period that is due to high volatility in the company’s common stock. When an entity’s common stock trades very infrequently and in such a way that an average of closing common stock prices is not meaningful, it would be acceptable for an entity to use the average of the bid-and-ask price for the common stock to determine the average market price. This method should be applied until the entity’s common stock trades regularly and an average of closing prices becomes more appropriate.
Another situation in which additional consideration is required is the
determination of average market prices in pre-IPO periods. As discussed in
Section 8.6
and Appendix B,
diluted EPS may need to be presented on the face of the income statement, in
pro forma disclosures, or both when an entity’s financial statements are
included in a registration statement filed with the SEC for an IPO of common
stock. In these situations, observable prices of an entity’s common stock
may be limited or altogether unavailable. As a result, the entity will need
to consider valuations of its common stock. Such valuations, whether
calculated internally or by a third party, must be prepared by using
generally accepted valuation principles and must conform to the fair value
measurement principles in ASC 820. An entity should consider any valuations
prepared for the purpose of recognizing compensation cost for consistency
with share-based payment arrangements.
While the number of periods related to deriving an average
market price depends on the facts and circumstances, the calculation of the
average market price should take into account common stock prices for the
entire reporting period because ASC 260-10-55-4 requires that the average be
meaningful. Therefore, when an entity consummates an IPO during a fiscal
year, the average market price for the period should include (1) the stock
price before the IPO, determined through the entity’s valuations of common
stock (i.e., its IRC Section 409A valuations), and (2) the publicly traded
stock prices for periods after the IPO. An entity cannot solely use its
publicly traded stock price to calculate the average market price for the
entire reporting period. In addition, an entity cannot assume that its
publicly traded stock price upon IPO effectiveness represents the market
price for the portion of the fiscal year that occurred before the IPO.
4.2.2.1.3.1 Contracts That Are Issued, Exercised, Forfeited, or Canceled, or That Expire, During a Financial Reporting Period
ASC 260-10-45-26 states, in part, that “[d]ilutive options or warrants that are issued during a period or that expire or are cancelled during a period shall be included in the denominator of diluted EPS for the period that they were outstanding [and] dilutive options or warrants exercised during the period shall be included in the denominator for the period prior to actual exercise.” To meet the ASC 260 requirement under which diluted EPS must include incremental common shares weighted for the period in which an option, warrant, nonvested share, forward sale contract, or similar instrument was outstanding during a financial reporting period, the average market price used to apply the treasury stock method should reflect an average over the period in which the instrument was outstanding rather than an average over the entire financial reporting period. Thus, for contracts that are issued, exercised, forfeited, or canceled, or that expired, during a financial reporting period, an entity will need to calculate, on an instrument-by-instrument basis, the average market price for the portion of the period in which the instrument was outstanding. The average market price over the entire financial reporting period is used for all other instruments that were outstanding for the entire reporting period. See Example 4-2 for an illustration of an option exercised during a period.
For share-based payment awards, the average unrecognized cost, which is a
component of proceeds, should also be based on an average during the
period in which the award was outstanding. See also Section
7.1.2.1.
Connecting the Dots
As discussed in Section 4.2.2.1.3, ASC 260 offers some inherent flexibility, or practical
approaches, related to the calculation of the average market price that is used to apply the
treasury stock method. An entity may have a number of potential common shares that were
not outstanding during the entire financial reporting period because of issuances, exercises, or
cancellations. If the entity is able to determine that using the average market price for the entire
financial reporting period to calculate the dilutive impact of such potential common shares
reasonably approximates the dilutive effect that would exist if the average market price were
separately calculated on an instrument-by-instrument basis by using the period in which each
instrument was outstanding, it would be reasonable for the entity to use the average market
price for the entire period even though this approach is less precise. The entity would still need
to weight the incremental common shares that result from the treasury stock method for the
period in which those potential common shares were outstanding during the financial reporting
period. In determining whether it is appropriate to employ a more practical approach in which
the average market price for the entire financial reporting period is applied because it closely
approximates the result that would be achieved if the average market price was calculated on an
instrument-by-instrument basis by using the period each instrument was outstanding, entities
may want to consider factors such as the following:
- The volatility in the market price of the entity’s common stock during the financial reporting period.
- The number of potential common shares that were not outstanding for the entire financial reporting period (i.e., as a measure of the potential impact that such potential common shares could have on diluted EPS for the period).
- The impact that potential common shares generally have on reported diluted EPS. The less sensitive the calculation of diluted EPS is to changes in assumptions, the more likely it is that using the average market price during the entire financial reporting period for all potential common shares is appropriate.
- The timing within the period in which potential common shares were issued, exercised, or canceled. The more even the distribution of issuances, exercises, or cancellations when amount and timing are considered, the more likely it is that using the average market price during the entire financial reporting period for all potential common shares is appropriate.
Another way to apply the treasury stock method by using the average market price
for the period is to weight the potential common shares and
apply the average market price for the entire period. However,
this approach may only be appropriate when the potential common
shares are of the same type and have the same terms. See
Examples
7-2 and 7-3.
4.2.2.2 Contracts to Sell Convertible Securities
ASC 260-10
Options and Warrants and Their Equivalents
55-6
Options or warrants to purchase convertible securities
shall be assumed to be exercised to purchase the
convertible security whenever the average prices of both
the convertible security and the common stock obtainable
upon conversion are above the exercise price of the
options or warrants. However, exercise shall not be
assumed unless conversion of similar outstanding
convertible securities, if any, also is assumed. The
treasury stock method shall be applied to determine the
incremental number of convertible securities that are
assumed to be issued and immediately converted into
common stock. Interest or dividends shall not be imputed
for the incremental convertible securities because any
imputed amount would be reversed by the if-converted
adjustments for assumed conversions.
55-7 Paragraphs 260-10-55-9
through 55-11 provide guidance on how certain options
and warrants should be included in the computation of
diluted EPS. Exercise of the potential common shares
discussed in those paragraphs shall not be reflected in
diluted EPS unless the effect is dilutive. Those
potential common shares will have a dilutive effect if
either of the following conditions is met:
- The average market price of the related common stock for the period exceeds the exercise price.
- The security to be tendered is selling at a price below that at which it may be tendered under the option or warrant agreement and the resulting discount is sufficient to establish an effective exercise price below the market price of the common stock obtainable upon exercise.
Although the treasury stock method does apply to options or warrants that allow the counterparty to purchase convertible securities, its application must be altered to reflect that the option or warrant is first settled by delivery of a convertible security, which may then be converted into common stock. For an option or warrant on convertible securities to be dilutive, the average market prices of both the convertible security and the common stock obtained upon conversion must exceed the exercise price of the option or warrant. See Example 4-7 for an illustration of the application of the treasury stock method to an option on convertible preferred stock. If an option or warrant contains multiple exercise or conversion alternatives, the guidance in ASC 260-10-55-9 through 55-11 must be considered. See Section 4.6 for more information.
An entity may enter into a forward contract to sell a convertible security
(although this is not commonly seen in practice). For this type of contract, the
entity and counterparty have agreed on the terms of the convertible security and
purchase price but will not exchange the purchase price and security until a
later settlement date. The dilutive effect, if any, resulting from a forward
contract to sell a convertible security should be calculated by using the
treasury stock method. As with the application of the treasury stock method to
options or warrants to sell convertible securities, the calculation under the
treasury stock method must take into account the common shares that would be
issuable if the contract was settled for the convertible security and
immediately converted into common stock. As a result, the treatment of a forward
contract to sell a convertible security would be consistent with that for a
forward contract to sell a common stock. The entity assumes that the forward
price is used to purchase common shares, and the excess of the common shares
issuable under the forward contract (based on the conversion rate when the
forward sale contract is on a convertible security) over the common shares
assumed repurchased at the average market price is included in the denominator
in the calculation of diluted EPS. However, once the forward contract is settled
and the convertible security is issued, diluted EPS is determined consistently
with the treatment of other outstanding convertible securities. See Example 4-8 for an
illustration of the application of the treasury stock method to a forward
contract to sell convertible debt. See Chapter 6 for further discussion of the
calculation of diluted EPS for outstanding convertible debt securities.
Connecting the Dots
Economically, the counterparty to a forward contract on a convertible security is “long” with
respect to the convertible security. Nevertheless, the if-converted method is not applied to a
forward contract to sell a convertible security. Under the if-converted method, interest and
dividends must be added back to the numerator. As discussed in ASC 260-10-55-6, if interest
and dividends were imputed on the convertible security underlying a forward contract to sell
a convertible security, they would be immediately reversed by the assumed conversion of
the convertible security into common shares. The only way the if-converted method could be
applied to a forward contract to sell a convertible security would be to assume that the common
shares underlying the convertible security were outstanding. However, unless the forward price
was zero or nominal, this assumption would be inappropriate because it would fail to consider
that an entity can use the proceeds received on payment of the forward price to purchase
common shares. The concept underlying the calculation of diluted EPS is that the entity deploys
any proceeds received from the issuance of potential common shares in a capital-efficient
manner (i.e., to reduce dilution or increase diluted EPS). When the entity applies the treasury
stock method, the dilution caused by issuing more common shares is offset by an assumed
repurchase of common shares with the proceeds.
4.2.2.3 Method of Settlement
4.2.2.3.1 Contracts Classified as Assets or Liabilities
Options, warrants, nonvested shares, forward sale contracts, and similar
instruments on the sale of common shares or potential common shares may be
classified as assets or liabilities. When a contract is classified as an
asset or a liability, the entity should first determine whether the treasury
stock method should be applied to calculate the impact of the contract on
diluted EPS. If the contract must be cash-settled in all circumstances
(i.e., no common shares will be issued on settlement), the treasury stock
method should not be applied and no adjustment should be made to the
numerator or denominator in the entity’s calculation of diluted EPS.
If dilutive, the treasury stock method is applied when (1) a contract must be
share-settled or (2) the entity or the counterparty is permitted to settle
the contract in cash or common shares. Because it is assumed, under the
treasury stock method, that a contract is classified as an equity instrument
(and that the income statement effect of the contract would not have
occurred if it had been exchanged for common shares at the beginning of the
period or on the date of issuance, if later), an entity must, in addition to
adding the incremental shares to the denominator, adjust the numerator when
a contract is classified as an asset or liability. The numerator adjustment
should reflect the change in net income that would have occurred during the
reporting period if the contract had been classified in equity. Since
contracts subject to the treasury stock method that are classified as assets
or liabilities are typically measured at fair value, with changes in fair
value recognized in earnings, and contracts classified as equity instruments
are typically not remeasured, the adjustment to the numerator will typically
reflect a reversal of the mark-to-market adjustment recognized on the
contract during the reporting period, net of any associated income tax
effects.12 However, the numerator adjustment should not be made, and the
incremental shares should not be added to the denominator, if (1) the
contract is an option or warrant and is out-of-the-money on the basis of a
comparison of the exercise price with the average market price or (2) the
aggregate effect of the two adjustments is antidilutive on the basis of the
antidilution sequencing requirements in ASC 260. See Section 4.7 for
further discussion of the accounting for diluted EPS for contracts subject
to the treasury stock method that are classified as assets or
liabilities.
4.2.2.3.2 Contracts Classified as Equity Instruments That Provide for Net-Share Settlement
Under the treasury stock method, it is assumed that contracts are settled physically or on a “gross” basis (i.e., the counterparty pays the exercise price or forward price and receives the gross number of common shares underlying the contract). Contracts subject to the treasury stock method often provide for net-share or “cashless” settlement. In a cashless settlement, the entity delivers to the counterparty a number of common shares with a current fair value (or a fair value determined on the basis of an average stock price) equal to the intrinsic value of the contract. The number of common shares delivered by the entity to the counterparty may be reduced by a number of shares with a fair value equal to the entity’s tax withholding requirements.
Economically, a net-share settlement of a contract to issue shares is equivalent
to a physical settlement accompanied by a repurchase of shares with the
proceeds paid by the counterparty. However, the treasury stock method
requires an assumption that the entity repurchases common shares at the
average market price during the financial reporting period; on the other
hand, in a net-share settlement, the number of shares “repurchased” is based
on the fair value of shares as of the settlement date or a weighted-average
price over a specified period that differs from the average market price
over the reporting period. Given the concept of an average market price that
must be applied under ASC 260, contracts that allow for net-share settlement
should be assumed to be exercised on a gross basis, with the dilution
calculated under the treasury stock method.
Connecting the Dots
Settlement of options, warrants, and nonvested shares, net of the entity’s
statutory withholding requirements, generally applies only to
share-based payment arrangements; in certain circumstances, however,
such features are included in an arrangement that is not a
share-based payment award (e.g., options or warrants on partnership
interests). In these withholding arrangements, whether the entity
settles by issuing gross shares or by issuing shares net of
statutory withholding requirements, the calculation of the dilutive
effect under the treasury stock method is not affected. To include
only the net shares issuable in the denominator of diluted EPS would
be contrary to the antidilution guidance in ASC 260. In a
withholding for statutory tax requirements, the entity is
economically issuing the gross number of shares and then buying back
shares from the counterparty. Since ASC 260 prescribes the treatment
of the repurchase of common shares under the treasury stock method,
any additional consideration of the net shares withheld to meet
statutory withholding requirements would inappropriately result in
taking into account the shares repurchased twice. Except for certain
forward contracts to repurchase common shares (addressed in ASC
480-10- 45-4), the repurchase of common shares, even if it depends
only on the passage of time, is not taken into account in in the
calculation of diluted EPS before the shares are repurchased.
4.2.2.3.3 Contracts Classified as Equity Instruments That Provide for Net-Cash Settlement
Options, warrants, nonvested shares, forward sale contracts, and similar
instruments on the sale of common shares or potential common shares that are
classified as equity instruments may permit the entity to choose to settle
the contract in cash or common stock. For these contracts, the treasury
stock method must be applied because ASC 260 prevents an entity from
overcoming the presumption of net share settlement.
If an equity-classified contract is antidilutive under the treasury stock
method, the entity would not reflect an adjustment to the numerator under
the assumption that the contract was classified as an asset or liability,
even if it would be dilutive to do so. Numerator adjustments are only made
to contracts classified as assets or liabilities that are considered
share-settled for diluted EPS.
4.2.2.3.4 Contracts With Multiple Conversion or Settlement Alternatives
Certain contracts subject to the treasury stock method may offer the
counterparty alternatives related to the consideration that it transfers to
exercise, convert, or settle the contract in return for common shares issued
by an entity. For example, a counterparty to a call option on common stock
may be permitted to pay the exercise price in either cash or delivery of an
entity’s debt instrument. ASC 260-10-55-8 through 55-11 address implications
related to the calculation of diluted EPS for contracts with multiple
conversion or settlement alternatives. ASC 260-10-55-8 states, in part, that
“[w]hen several conversion alternatives exist, the computation shall give
effect to the alternative that is most advantageous to the holder of the
convertible security.” For contracts that offer the counterparty such
alternatives with respect to the payment of the exercise or forward price,
the guidance in ASC 260-10-55-8 through 55-11 must be applied to reflect the
potential dilutive impact on diluted EPS. See further discussion in
Section
4.6.
4.2.3 Examples
ASC 260-10
Example 15: Options, Warrants, and Their Equivalents
55-92 This Example illustrates the guidance in paragraphs 260-10-45-22 through 45-23.
55-93 Consider Entity A that has 10,000 warrants outstanding exercisable at $54 per share; the average market price of the common stock during the reporting period is $60. Exercise of the warrants and issuance of 10,000 shares of common stock would be assumed. The $540,000 that would be realized from exercise of the warrants ($54 × 10,000) would be an amount sufficient to acquire 9,000 shares ($540,000/$60). Thus, 1,000 incremental shares (10,000 – 9,000) would be added to the outstanding common shares in computing diluted EPS for the period.
55-94 The following is a
shortcut formula for that computation (note that this
formula may not be appropriate for share-based compensation
awards [see paragraph 260-10-45-29]):
Incremental shares = [(market price – exercise
price)/market price] × shares assumed issued under
option; thus, [($60 – $54)/$60] × 10,000 = 1,000
incremental shares.
Example 4-1
Warrant to Sell Common Stock — Number of Common Shares and Exercise Price Vary Over Time
In conjunction with a debt issuance, on June 15, 20X2, Company D issued a warrant to Company H under which H has the right, but not the obligation, to purchase D’s common shares at any time from the issuance date until June 15, 20X7. The warrant contains the following key terms:
- Notional amount — H can exercise the warrant for a number of common shares that varies depending on the date of exercise as follows:
- If exercised before June 15, 20X3 — 50,000 common shares.
- If exercised between June 15, 20X3, and June 14, 20X4 — 52,500 common shares.
- If exercised between June 15, 20X4, and June 14, 20X5 — 55,000 common shares.
- If exercised between June 15, 20X5, and June 14, 20X6 — 57,500 common shares.
- If exercised between June 15, 20X6, and June 15, 20X7 — 60,000 common shares.
- Exercise price — The exercise price for each common share purchased varies depending on the date of exercise as follows:
- If exercised before June 15, 20X3 — $10.00 per common share.
- If exercised between June 15, 20X3, and June 14, 20X4 — $9.75 per common share.
- If exercised between June 15, 20X4, and June 14, 20X5 — $9.50 per common share.
- If exercised between June 15, 20X5, and June 14, 20X6 — $9.25 per common share.
- If exercised between June 15, 20X6, and June 15, 20X7 — $9.00 per common share.
From H’s perspective, it is most advantageous to wait and exercise the warrant between June 15, 20X6,
and June 15, 20X7, because H pays a lower exercise price and is entitled to receive more common shares.
Therefore, D should apply the treasury stock method, if dilutive, assuming a $9.00 exercise price per common
share on 60,000 potential common shares.
Example 4-2
Option to Sell Common Stock — Option Is Exercised During the Period
Assume the following:
- In 20X7, Company N issued options that allow the counterparty to purchase 10,000 shares of common stock at an exercise price of $27.50 per common share.
- The counterparty may elect to exercise the options on a physical or net-share-settlement basis.
- On March 2, 20X8, the counterparty exercised all the options in a net-share settlement.
- Company N uses a weekly average to calculate the average market price for its quarterly financial reporting period ended March 30, 20X8, because it has concluded that a weekly average closely approximates a daily average. The weekly average is based on the closing stock price of N’s common stock on the last day of each week. The quoted closing prices of N’s common stock were as follows:
-
January 5, 20X8: $32.23.
-
January 12, 20X8: $31.77.
-
January 19, 20X8: $32.93.
-
January 26, 20X8: $33.12.
-
February 2, 20X8: $33.88.
-
February 9, 20X8: $32.71.
-
February 16, 20X8: $34.03.
-
February 23, 20X8: $34.48.
-
March 2, 20X8: $36.00.
-
March 9, 20X8: $35.55.
-
March 16, 20X8: $35.01.
-
March 23, 20X8: $34.16.
-
March 30, 20X8: $33.08.
-
The following calculation shows the incremental common shares that would be
added to the denominator in the calculation of diluted EPS,
if the shares are dilutive, on the basis of an assumption
that the options were exercised at the beginning of the
period:
The incremental common shares added to diluted EPS of 1,193, along with the weighted-average common shares outstanding when the options are exercised, represent the total impact that the options had on diluted EPS.
If N determined that the average market price for the entire quarterly reporting period was a reasonable approximation of the average market price during the period the options were outstanding, the incremental common shares would have been calculated as follows:
Example 4-3
Forward Contract to Sell
Common Shares — Number of Common Shares Varies on the
Basis of the Stock Price
Some entities enter into forward contracts
that require the counterparty to purchase a fixed dollar
amount of the entity’s common shares on a future date. The
number of common shares purchased varies on the basis of the
entity’s common stock price. These contracts may be referred
to as variable share forwards or range forwards. Although
such contracts may be entered into on a stand-alone basis,
they are commonly entered into as part of a unit offering
that goes by many different names (e.g., Feline PRIDES,
Upper DECS, MEDS, and PIES). The unit offerings also include
a debt instrument with a principal amount equal to the
forward price of the forward contract and a maturity date
that coincides with the settlement date of the forward
contract.
Assume that Company A enters into a
variable-share forward contract with Investment Bank G that
requires G to purchase A’s common stock for $50 in two
years. The market price of A’s common stock on the date the
forward contract is entered into is $50 per share. The
forward contract contains the following key terms:
-
Issuance date — December 31, 20X0.
-
Settlement date — December 31, 20X2, or earlier at the option of A.
-
Unit price — $50.
-
Forward price cap — $60.
-
Forward price floor — $50.
-
Settlement price — The volume-weighted average closing price for the 20 trading days ending 3 trading days immediately preceding the settlement date (the “average settlement price”).
The number of common shares that G will
receive upon settlement will depend on the average closing
price of A’s common stock for a specified period immediately
preceding the settlement date of the forward contract.
Specifically:
-
If the average settlement price is greater than the forward price cap, G receives 0.833 shares.
-
If the average settlement price is less than the forward price cap but equal to or greater than the forward price floor, G receives a number of common shares equal to the average settlement price divided by $50 (i.e., $50 worth of common stock).
-
If the average settlement price is less than $50, G receives one share of common stock.
The forward contract described above is
subject to the treasury stock method of calculating diluted
EPS; however, in certain situations, the terms of the
offering may require application of the if-converted method
(see Section 4.8.3.6). For variable-share forward
contracts, the treasury stock method is applied as
follows:
-
Number of shares issued — Since the number of common shares issuable varies on the basis of the entity’s stock price, A applies the guidance on variable denominators in ASC 260-10-45-21A. In accordance with this guidance, diluted EPS must reflect the number of common shares that would be issued on the basis of A’s average stock price during the entire reporting period.
-
Number of shares repurchased — ASC 260 also requires that the average stock price be used to calculate the number of common shares assumed to be repurchased. This calculation would be based on the average market price of A’s common stock during the entire financial reporting period (or the period in which the contract was outstanding during the reporting period if the contract was entered into or settled during the reporting period).
Below are various calculations of the impact
of the forward contract on diluted EPS for A’s quarterly
financial reporting period ended March 31, 20X1. For each
scenario, the average settlement price is calculated in
accordance with the guidance in ASC 260-10-45-21A (i.e., on
the basis of A’s average stock price during the reporting
period — that is, the average of the daily closing quoted
prices of A’s common stock for the entire quarterly
financial reporting period). It is assumed that these
contracts are not participating securities and that the
two-class method therefore does not apply.
Scenario 1 — Average
Market Price for Period Is $40
Scenario 2 — Average
Market Price for Period Is $50
Scenario 3 — Average
Market Price for Period Is $60
Scenario 4 — Average
Market Price for Period Is $70
As illustrated in these calculations, (1) in
all scenarios, the average settlement price equals the
average stock price during the reporting period, and (2)
this arrangement is dilutive only when the average market
price for the entire financial reporting period exceeds the
forward cap of $60.
Example 4-4
Forward Contract to Sell Common Shares — Forward Price Varies on the Basis of Specified Interest
Rate and Expected Dividends
On April 1, 20X1, Company X enters into a forward contract with Investment Bank
C that requires X to sell 21 million common shares to C no
later than December 31, 20X1 (the maturity date). While all
21 million common shares must be sold and delivered to C no
later than the maturity date, if sufficient notice is given,
X may deliver all or a portion of the shares at any time
between the trade date and the maturity date. Upon an early
termination event, X is required to deliver any remaining
common shares to C. Company X has classified the forward
contract in equity, and it does not represent a
participating security. For diluted EPS purposes, physical
share settlement of the contract must be assumed.
Significant terms of the forward contract are as follows:
- The initial forward price on the trade date is $22.00 per share.
- On any day after the trade date, the forward price is equal to the forward price on the immediately preceding calendar day multiplied by the sum of 1 and the daily rate for this day, provided that the purchase price in effect on each forward price reduction date will equal the purchase price otherwise in effect on this date minus the forward price reduction amount for this date.
- The daily rate is the USD federal funds rate minus 0.5 percent (the “spread”) divided by 365.
- The forward price reduction dates are May 1, 20X1; August 1, 20X1; and November 1, 20X1.
- The forward price reduction amount is $0.25 for each forward price reduction date.
Company X is calculating diluted EPS for its quarterly financial reporting
period ended June 30, 20X1. The average market price of X’s
common stock during the reporting period is $23.50 per
share. The forward price as of June 30, 20X1, is $21.96. The
lowest forward price during the reporting period is $21.83,
which occurs on the May 1, 20X1, forward price reduction
date. The average forward price during the reporting period
is $21.90.
The forward price varies daily depending on the USD federal funds rate. Depending on the level of interest rates, the daily adjustments could increase or reduce the forward price. If the USD federal funds rate is less than 0.5 percent, the forward price will decline daily. If the USD federal funds rate exceeds 0.5 percent, the forward price will increase daily. The forward price will also decrease by a fixed amount on each forward price reduction date.
To calculate the dilutive effect of the forward contract under the treasury
stock method, as discussed in Section 4.2.2.1.2.1, X
may apply as an accounting policy any of the following three
approaches to calculate the proceeds:
-
View A — The proceeds reflect the forward price as of the end of the reporting period.
-
View B — The proceeds reflect the lowest forward price during any day within the reporting period.
-
View C — The proceeds reflect the average forward price during the reporting period.
The alternative views under the treasury stock method for X’s financial reporting period ended June 30, 20X1, are as follows:
View A
View B
View C
In this example, if the USD federal funds rate stays constant from June 30, 20X1, to December 31, 20X1, because of the two remaining forward price reduction amounts, the forward price at maturity would be $21.46 per common share. However, an entity should not assume that the interest rate at the end of the reporting period stays constant until the maturity date and deduct the remaining forward price reduction amounts to arrive at a lower forward price at maturity. This approach would not reflect the forward price at maturity because interest rates may change.
It is acceptable for an entity to use any of the three approaches discussed
above when applying the treasury stock method, regardless of
whether the entity or counterparty controls the ability to
settle the contract before its stated maturity. However, it
is not appropriate to select one of the alternative views if
the forward price is fixed only on the basis of scheduled
reductions that are intended to approximate anticipated
dividends. See the example below for an illustration of this
concept.
Example 4-5
Forward Contract to Sell Common Shares — Fixed Forward Prices That Vary on the Basis of the
Settlement Date
On September 7, 20X4, Company D enters into a forward contract with Investment
Bank M that requires D to sell 10 million common shares to M
no later than May 16, 20X5 (the maturity date). While all 10
million common shares must be sold and delivered to M no
later than the maturity date, if sufficient notice is given,
D may deliver all or a portion of the shares at any time
between the trade date and the maturity date. Upon an early
termination event, D is required to deliver any remaining
common shares to M. Company D has classified the forward
contract in equity, and it does not represent a
participating security. For diluted EPS purposes, physical
share settlement of the contract must be assumed.
The forward price per common share sold is fixed at varying prices that depend on the delivery date(s) of
the shares. The fixed prices take into account both the time value of money and expected dividends on D’s
common stock. The forward prices are as follows:
Company D is calculating diluted EPS for its quarterly financial reporting period ended December 31, 20X4. The
average market price of X’s common stock during the reporting period is $64.50 per share.
Although only one fixed forward price may be operable on any given date, in accordance with ASC 260-10-
45-21, D should calculate diluted EPS in a manner that reflects the most disadvantageous outcome from D’s
perspective. Therefore, on each financial reporting period date, D should look at the then-effective forward
price and all future forward prices to determine which price is least advantageous to D. That settlement price
should be used to calculate the proceeds from the forward under the treasury stock method. This approach is
required regardless of whether the entity or counterparty controls the ability to settle the contract before its
stated maturity.
For the quarterly period ended December 31, 20X4, the dilutive effect of the forward contract is calculated as
follows:
The example below illustrates a forward sale contract with forward prices that
decline on the basis of actual dividends.
Example 4-6
Forward Contract to Sell Common Shares — Forward Price Varies on the Basis of Actual Dividends
On January 2, 20X5, Company E enters into a forward contract with Investment
Bank J that requires E to sell 25 million common shares to J
no later than December 31, 20X5 (the maturity date). While
all 25 million common shares must be sold and delivered to J
no later than the maturity date, if sufficient notice is
given, E may deliver all or a portion of the shares at any
time between the trade date and the maturity date. Upon an
early termination event, E is required to deliver any
remaining common shares to J. Company E has classified the
forward contract in equity, and it represents a
participating security. For diluted EPS, physical share
settlement of the contract must be assumed.
The forward price per common share sold is fixed at $65 per share, subject to adjustment only for standard antidilution events and cash dividends paid by E on its common shares. Company E typically pays a quarterly cash dividend of $1 per share on its common shares on March 15, June 15, September 15, and December 15.
Under the treasury stock method, the assumed proceeds should be based on the forward price at the end of the reporting period. While E may reasonably expect the forward price per share at maturity to decrease to $61 because of cash dividends it expects to declare, if only the passage of time is assumed, the forward price on each reporting date will not decline. Because E is under no obligation to pay any cash dividends on its common stock and E’s board of directors must declare a cash dividend before it is payable, under the treasury stock method, it should not be assumed that future dividends will be paid.
By contrast, when prespecified fixed adjustments are made to the forward price of a forward sale contract that are designed to represent anticipated dividends, upon the mere passage of time, the forward price will be adjusted; therefore, in accordance with ASC 260-10-45-21, the entity must assume that the proceeds will represent the lowest forward price during the remaining term of the contract. However, when the forward price is reduced only for actual dividends, because dividends do not need to be recognized under GAAP before they are declared, an entity is not required to anticipate the amount of future dividends that will be declared in determining proceeds under the treasury stock method. Rather, the forward contract is a participating security and distributed and undistributed earnings are taken into account in the calculation of basic EPS by using the two-class method. Diluted EPS is based on the more dilutive of the treasury stock method or the two-class method.
Example 4-7
Option to Sell Convertible Preferred Stock
Assume the following:
- On January 1, 20X1, Company G issues 1,000 options that allow the counterparty to purchase a share of convertible preferred stock at $5,000 per share.
- The convertible preferred stock is convertible into common stock at $25 per share at any time after two years (i.e., the holder can receive 200 shares of common stock for each share of convertible preferred stock).
- The convertible preferred stock pays an annual dividend of $500 per share.
- On the date the options are issued, G’s common stock is trading at $25 per share.
- For the period ended December 31, 20X3, G’s common stock has an average market price of $40 per share.
- For diluted EPS purposes, share settlement of the option must be assumed.
For the period ended December 31, 20X3, G must apply the treasury stock method to calculate diluted EPS
because the options are in-the-money from the perspective of the counterparty. Under the treasury stock
method, G must assume that the counterparties to the options would elect to exercise their options and
purchase convertible preferred stock, which they would then convert into common stock. The calculation of the
diluted impact of the options is as follows:
In this example, it is assumed that G classifies the option in equity. If the
option were classified as a liability, G would also need to
adjust the numerator if the aggregate effect of the
numerator adjustment and incremental common shares is
dilutive. See further discussion in Section
4.2.2.3.1 and Example 4-31.
Example 4-8
Forward to Sell Convertible Debt
On June 15, 20X1, Company Z enters into a forward contract to sell convertible debt securities to Investor A.
The forward contract requires settlement on June 30, 20X2. Company Z enters into the contract as a capital-raising
activity; however, since Z does not need the proceeds until the second half of 20X2 and A wants to lock
in the purchase price, the parties enter into the contract before the convertible debt securities are actually
issued.
According to the terms of the forward contract, A is required to pay $500 million to Z on June 30, 20X2, and Z is
required to issue $500 million of convertible debt securities to A with the following terms:
- Principal amount — $500 million (or $10,000 per debt security issued).
- Number of securities — 50,000.
- Maturity date — December 31, 20X9.
- Interest rate — 4 percent per annum, payable quarterly in arrears.
- Conversion terms — Convertible at any time after issuance at an initial conversion price of $25 per security, subject to adjustment for standard antidilution events, declining to $20 per security beginning on January 1, 20X9. Physical settlement is required for any conversion.
Company Z’s common stock price on the issuance date of the forward contract is
$17.50 per share (i.e., the conversion option in the
convertible debt instrument has no intrinsic value on the
issuance date of the forward).
Company Z is calculating diluted EPS for the third quarter ended September 30, 20X1, and has concluded
that it is not required to account for the forward contract as a liability, with changes in fair value recognized in
earnings. The average market price of Z’s common stock for the quarter ended September 30, 20X1, is $22.50
per share.
The dilutive impact of the forward contract to sell convertible securities is calculated as follows:
See Section 4.10 for a comprehensive example illustrating the use of the treasury stock method in the calculation of diluted EPS. See Section 7.1.2.1.5 for examples of the application of the treasury stock method to share-based payment arrangements.
Footnotes
7
The treasury stock method does not apply to purchased
options because they are always antidilutive (see Section 4.1.1.1).
8
The unpaid portion of a stock subscription
agreement and common stock issued in return for a note
receivable may be treated as written call options on common
stock in the calculation of diluted EPS. See Sections
4.8.3.1 and 4.8.3.2 for more
information.
9
It may be unclear whether an entity should
apply the guidance on contingently issuable shares
in ASC 260-10-45-48 through 45-57 or the guidance
on variable denominators in ASC 260-10-45-21A. In
these situations, entities must use judgment and
there could be diversity in practice. On the basis
of informal discussions with the FASB staff, we
understand that the amendments to ASC 260 made by
ASU 2020-06 were not intended to change how
entities determine whether the guidance on
contingently issuable shares applies. In those
discussions, the FASB staff acknowledged that the
guidance in ASC 260 that addresses what
constitutes a contingently issuable share is often
difficult to interpret in practice.
10
For more information about how the variability
in terms of an equity-linked financial instrument affects its
classification, see Chapter 4 of Deloitte’s
Roadmap Contracts on an Entity’s Own Equity.
11
The average is generally a simple average. The use
of a volume-weighted average is not necessarily more precise or more
representative of the average market price of the entity’s common
stock during a period.
12
If the contract represents a share-based payment
award, the adjustment to the numerator should only reflect the
incremental effect of the different accounting classification (i.e.,
the numerator is adjusted to reflect the compensation expense that
would have been recognized during the reporting period if the award
had been classified in equity). An adjustment to the proceeds is
also required because the average compensation cost not yet
recognized for financial reporting purposes must also be based on
the amount that would have been left unrecognized if the award had
been accounted for as an equity award. See further discussion in
Section
7.1.4.
4.3 Reverse Treasury Stock Method
4.3.1 Scope
ASC 260-10
Written Put Options and the Reverse Treasury Stock Method
45-35 Contracts that require
that the reporting entity repurchase its own stock, such as
written put options and forward purchase contracts other
than forward purchase contracts accounted for under
paragraphs 480-10-30-3 through 30-5 and 480-10-35-3, shall
be reflected in the computation of diluted EPS if the effect
is dilutive. If those contracts are in the money during the
reporting period (the exercise price is above the average
market price for that period), the potential dilutive effect
on EPS shall be computed using the reverse treasury stock
method. . . .
The reverse treasury stock method applies to contracts that require an entity to
repurchase its common stock. Such contracts include the following:13
-
Written put options (common stock) — Options written by an entity under which the counterparty has the right, but not the obligation, to sell a specified quantity or amount of common stock to the entity at a fixed or otherwise determinable price.
-
Forward purchase contracts (common stock) — Contracts that require the entity to purchase a specified quantity or amount of common stock from the counterparty at a future date at a fixed or otherwise determinable price.
An entity should not apply the reverse treasury stock method to a contract
listed above in the following situations:
-
The contract represents a forward contract to repurchase common stock that is within the scope of ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3 (see Section 4.8.4.1.1).
-
The contract must be net settled in cash (i.e., no common shares are purchased upon settlement).
-
The contract is a participating security and the two-class method of calculating diluted EPS is more dilutive than the reverse treasury stock method.
The discussion in Section 4.3.2 focuses on the application of the reverse treasury stock method to
potential common shares within its scope that are not participating securities. If a potential common
share is a participating security, an entity is required to apply the more dilutive of the reverse treasury
stock method or the two-class method of calculating diluted EPS (see Section 5.5.4). Sections 4.3.2.2.3
and 4.6 discusses the application of the reverse treasury stock method to instruments that contain
multiple settlement alternatives.
4.3.2 Application of the Reverse Treasury Stock Method
4.3.2.1 General
ASC 260-10
Conversion Rate or Exercise Price
45-21 Diluted EPS shall be
based on the most advantageous conversion rate or
exercise price from the standpoint of the security
holder. Previously reported diluted EPS data shall not
be retroactively adjusted for subsequent conversions or
subsequent changes in the market price of the common
stock.
Variable
Denominator
45-21A
Changes in an entity’s share price may affect the
exercise price of a financial instrument or the number
of shares that would be used to settle the financial
instrument. For example, when the principal of a
convertible debt instrument is required to be settled in
cash but the conversion premium is required to (or may)
be settled in shares, the number of shares to be
included in the diluted EPS denominator is affected by
the entity’s share price. In applying both the treasury
stock method and the if-converted method of calculating
diluted EPS, the average market price shall be used for
purposes of calculating the denominator for diluted EPS
when the number of shares that may be issued is
variable, except for contingently issuable shares within
the scope of the guidance in paragraphs 260-10-45-48
through 45-57. See paragraphs 260-10-55-4 through 55-5
for implementation guidance on determining an average
market price.
Written Put Options and the Reverse Treasury Stock Method
45-35 Contracts that require
that the reporting entity repurchase its own stock, such
as written put options and forward purchase contracts
other than forward purchase contracts accounted for
under paragraphs 480-10-30-3 through 30-5 and
480-10-35-3, shall be reflected in the computation of
diluted EPS if the effect is dilutive. If those
contracts are in the money during the reporting period
(the exercise price is above the average market price
for that period), the potential dilutive effect on EPS
shall be computed using the reverse treasury stock
method. Under that method:
-
Issuance of sufficient common shares shall be assumed at the beginning of the period (at the average market price during the period) to raise enough proceeds to satisfy the contract.
-
The proceeds from issuance shall be assumed to be used to satisfy the contract (that is, to buy back shares).
-
The incremental shares (the difference between the number of shares assumed issued and the number of shares received from satisfying the contract) shall be included in the denominator of the diluted EPS computation.
45-36 For example, an entity
sells 100 put options with an exercise price of $25; the
average market price for the period is $20. In computing
diluted EPS at the end of the period, the entity assumes
it issues 125 shares at $20 per share to satisfy its put
obligation of $2,500. The difference between the 125
shares issued and the 100 shares received from
satisfying the put option (25 incremental shares) would
be added to the denominator of diluted EPS.
The reverse treasury stock method represents a method of determining the dilutive effect of a contract that obligates an entity to purchase its common shares. Under this method, it is assumed that the entity raises the proceeds necessary to satisfy its obligation under the share purchase contract by issuing its common shares to market participants at the average market price during the period. The excess of the common shares assumed issued over the common shares purchased under the contract represents the incremental common shares under the reverse treasury stock method. Contracts that are subject to the reverse treasury stock method must be classified as liabilities (or assets in some circumstances) in accordance with ASC 480 regardless of whether they provide for settlement in cash or shares. As a result, under the reverse treasury stock method, an entity is required to adjust the numerator in addition to including incremental common shares. See further discussion in Section 4.3.2.2.1.
Like the treasury stock method (as discussed in Section 4.2.2.1), the reverse treasury
stock method is only applied to written put options that are in-the-money from
the perspective of the counterparty. This determination is based on a comparison
of the exercise price with the average market price of the entity’s common
stock. The reverse treasury stock method should not be applied to an
out-of-the-money written put option that would be dilutive to EPS because of the
adjustment made to the numerator to reverse the mark-to-market amount recognized
on the contract during the reporting period. However, because forward purchase
contracts must be settled regardless of whether they are in-the-money or
out-of-the-money, the reverse treasury stock method should be applied to forward
contracts if such contracts are dilutive. An entity would determine whether a
forward purchase contract is dilutive to EPS on the basis of the aggregate
effect of the numerator adjustment and the incremental common shares to be
included in the denominator under the reverse treasury stock method.
Connecting the Dots
A written put option that is in-the-money from the perspective of the
counterparty may be antidilutive because of the adjustment to the
numerator to reverse the mark-to-market amount recognized on the
contract during the reporting period. ASC 260-10-45-17 precludes the
inclusion of this antidilutive effect in the calculation of diluted
EPS.
If a contract subject to the reverse treasury stock method is a participating security, the more dilutive of the reverse treasury stock method or the two-class method must be applied, as discussed in Section 5.5.4.
4.3.2.1.1 Adjustments to the Number of Shares Purchased Upon Settlement
The number of common shares to be purchased upon settlement of a written put option or forward purchase contract may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence of a specified event; or (3) a specified rate, price, index, or other variable.
If the number of common shares purchased upon settlement varies only on the basis of the passage of time, the entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any settlement term that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty.
If the number of common shares purchased upon settlement is subject to
adjustment on the basis of the occurrence or nonoccurrence of a specified
event (other than changes in the fair value of the entity’s stock price)
that is not within the counterparty’s control, the entity should apply the
guidance on contingently issuable shares to determine the number of common
shares to be purchased on settlement. As discussed in Section 4.5, the
entity should assume that the current status of the condition as of the
reporting date will remain unchanged (i.e., the specified event will not
occur). As a result, potential adjustment features that are commonly
included in the terms of instruments subject to the reverse treasury stock
method will have no impact on the application of the reverse treasury stock
method until such adjustment events occur. Table 4-3 lists common adjustment
events that will have no impact on the application of the reverse treasury
stock method before the occurrence of the related event.
If the number of common shares to be purchased upon settlement is linked to a
specified rate, price, index, or other variable, the entity should determine
the number of shares (see Table 4-5) by applying either (1) the guidance in ASC
260-10-45-21A on variable denominators or (2) the guidance in ASC
260-10-45-48 through 45-57 on contingently issuable shares. Under the
variable denominator approach, the entity would determine the number of
common shares that would be purchased upon settlement on the basis of the
average of the specified rate, price, index, or other variable during the
reporting period. As discussed in Section 4.5, under the contingently
issuable share approach, the entity would reflect the number of common
shares that would be purchased upon settlement on the basis of the current
rate, price, index, or other variable at the end of the reporting period (or
on the basis of the average rate, price, index, or other variable, assuming
settlement occurred on the last day of the reporting period if the contract
stipulates an average rate, price, index, or other variable). As discussed
in Section
4.3.2.1.3, under either approach, the stock price used to
calculate the number of common shares assumed to be issued to pay the
purchase price of the written option or forward purchase contract must
reflect the average market price during the entire financial reporting
period (or portion thereof during the reporting period in which the contract
was outstanding). Since contracts subject to the reverse treasury stock
method are classified as assets or liabilities and typically recognized at
fair value, with changes in fair value reported in earnings, an entity must
also adjust the numerator in calculating diluted EPS under the reverse
treasury stock method, as discussed in Section 4.3.2.2.1.
Table
4-5
Determining the Number of Shares to
Be Purchased Upon Settlement When the Shares Vary on
the Basis of a Specified Rate, Price, Index, or
Other Variable
| |
---|---|
Type of Variable
|
Approach Used
|
Entity’s stock price
|
Average market price approach
|
Other rate, price, index, or
variable
|
Average market price approach or
contingently issuable share method
|
Although ASC 260-10-45-21A does not specifically refer to
the reverse treasury stock method, an entity must use the average market
price approach if the number of shares varies solely on the basis of the
entity’s stock price. Arrangements subject to the reverse treasury stock
method would not be expected to qualify for the contingently issuable share
approach under ASC 260 because any arrangement in which an entity receives
its own shares for little or no consideration would generally be
antidilutive in the calculation of diluted EPS. However, an entity can
choose to apply either the average market price approach or contingently
issuable share method as an accounting policy if the variability is due to
something other than just the entity’s stock price, since ASC 260-10-45-21A
only specifically addresses how an entity accounts for diluted EPS when the
variable is based on the entity’s stock price.
Connecting the Dots
As noted in the table above, the number of common shares assumed to be purchased
may be determined on the basis of conditions at the end of the
reporting period when the number of common shares assumed to be
issued to pay the purchase price is based on the average market
price over the entire financial reporting period. In such
circumstances, a written put option or forward purchase contract on
a number of common shares that varies on the basis of a rate, price,
index, or market variable other than stock price may be dilutive, or
in-the-money, for diluted EPS purposes even if the contract is
out-of-the-money from the perspective of the counterparty on the
basis of the market price of the entity’s common stock as of the end
of the reporting period.
4.3.2.1.2 Proceeds
The determination of the proceeds used to apply the reverse treasury stock method is generally
straightforward. The proceeds represent the amount the entity would need to raise to pay the purchase
price to acquire common shares under the contract (i.e., the exercise price or forward price). However,
as discussed below, an entity must take additional considerations into account in certain situations.
4.3.2.1.2.1 Adjustments to the Exercise Price or Forward Price
The exercise price or forward price of a written put option or forward purchase contract may vary
because of (1) the passage of time; (2) the occurrence or nonoccurrence of a specified event; or (3) a
specified rate, price, index, or other variable.
If the exercise price or forward price varies only on the basis of the passage of time, the entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any exercise price or forward price that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty.
If the exercise price or forward price is subject to adjustment on the basis of
the occurrence or nonoccurrence of a specified event (other than changes
in the fair value of the entity’s stock price) that is not within the
counterparty’s control, the entity should apply the guidance on
contingently issuable shares to determine the exercise price or forward
price. As discussed in Section 4.5, the entity should assume that the current
status of the condition on the reporting date will remain unchanged
(i.e., the specified event will not occur). As a result, potential
adjustment features that are commonly included in the terms of
instruments subject to the reverse treasury stock method will have no
impact on the application of the reverse treasury stock method until
such adjustments occur. Table 4-3 lists common adjustment
events that will have no impact on the application of the reverse
treasury stock method before the occurrence of the related event.
If the exercise price or forward price varies solely on the basis of the
entity’s stock price, the entity should apply ASC 260-10-45-21A, which
requires that the entity determine the purchase price by using the
average market price of the entity’s stock during the reporting period.
If, however, the exercise price or forward price varies on the basis of
a specified rate, price, index, or other variable (i.e., it is not based
solely on the entity’s stock price), an entity may apply any of the
following approaches since ASC 260 does not contain specific guidance on
this matter:
-
View A: The purchase price reflects the exercise price or forward price as of the end of the reporting period — This view is consistent with the guidance on contingently issuable shares in ASC 260. Although that guidance only specifically addresses how to determine the number of common shares, it may be applied by analogy to determine the exercise price or forward price. Under that guidance, it is assumed that the contingency (in this case, the amount of the exercise price or forward price) is resolved as of the end of the reporting period. Thus, an entity calculates the exercise price or forward price on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming settlement of the contract on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 for additional discussion of the contingently issuable share method.
-
View B: The purchase price reflects the highest exercise price or forward price during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires that diluted EPS be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the exercise or forward prices applicable for the entire time during the reporting period in which the contract was outstanding and should use the price that is least advantageous to the entity and produces the highest purchase price. The entity should not project future exercise or forward prices since they will vary on the basis of changes in the rate, price, index, or other variable.
-
View C: The purchase price reflects the average exercise price or forward price during the reporting period — This view is consistent with ASC 260-10-45-21A and ASC 260-10-45-35, which require the use of an average.
These three approaches are acceptable regardless of whether the entity or
counterparty controls the timing of the settlement date (since neither
party ultimately controls the rate, price, index, or other variable that
affects the purchase price). The approach selected is considered an
accounting policy election that must be applied consistently and
disclosed.
Under the reverse treasury stock method, the purchase price payable by the
entity to settle a written put option or forward repurchase contract is
used to determine the number of common shares that the entity would be
assumed to issue to pay the purchase price. Under any of the three
approaches described above that are used to determine the purchase
price, the entity must assume that it issues common shares to pay the
purchase price at the average market price during the reporting period
(see Section
4.3.2.1.3). In addition, since contracts subject to the
reverse treasury stock method are classified as assets or liabilities
and typically recognized at fair value, with changes in fair value
reported in earnings, the calculation of diluted EPS should include an
adjustment to the numerator, as discussed in Section 4.3.2.2.1.
It is not acceptable to determine the proceeds on the basis of the exercise
price or forward price at the beginning of the reporting period because
there is no basis in ASC 260 for the use of this approach.
Connecting the Dots
When the exercise price or forward price of a written put option or forward purchase contract
subject to the reverse treasury stock method is automatically adjusted solely on the basis of
prespecified adjustments designed to represent the amount of dividends the entity is expected
to declare on typical dividend declaration dates, the highest exercise price or forward price that
may apply during the remaining term of the contract on the basis of only the passage of time
(which will generally be the exercise price or forward price as of the reporting date) must be
used in applying the reverse treasury stock method. This requirement results from the guidance
in ASC 260-10-45-21, which applies to adjustments to the exercise price or forward price that
are made on the basis of the mere passage of time. This requirement is applicable regardless
of whether the entity or counterparty controls the ability to settle the contract before its
stated maturity. Because the average market price used to determine the number of common
shares that would need to be issued to pay the purchase price will not yet reflect these future
dividends, this approach will often exacerbate the dilution under the reverse treasury stock
method. If the contract can only be exercised or settled before its stated maturity date upon
the occurrence of a contingent event that is not within the control of the counterparty, the
guidance on adjustments to the exercise price or forward price on the basis of the occurrence
or nonoccurrence of a specified event that is not within the counterparty’s control is applicable
(i.e., the guidance on contingently issuable shares in ASC 260-10-45-54).
If adjustments to the exercise price or forward price of a written put option or forward purchase
contract subject to the reverse treasury stock method occur only when and if the entity declares
a dividend on its common stock, the purchase price used to apply the reverse treasury stock
method should not reflect the impact of future dividends before their declaration. This is
because the entity is under no obligation to pay any cash dividends on its common stock and,
in the absence of the declaration of a cash dividend, the exercise price or forward price will not
change upon the mere passage of time.
4.3.2.1.2.2 Prepaid Contracts
A prepaid forward purchase contract is not subject to the reverse
treasury stock method because its application would always be
antidilutive. A prepaid written put option for which the prepayment is
not refundable (i.e., the issuing entity pays the exercise price net of
any option premium and is not entitled to a return of the prepaid amount
if the option is not exercised) is the economic equivalent of a prepaid
forward purchase contract in the calculation of diluted EPS. Therefore,
this contract is also not subject to the reverse treasury stock method
because it would be antidilutive.
In the case of a prepaid written put option for which the issuing entity
pays the exercise price net of any option premium up front and is
entitled to receive a return of the exercise price, the accounting for
diluted EPS will depend on the specific terms of the arrangement. If the
issuing entity has the option of receiving its prepayment back before
the expiration of the written put option, the prepayment should be
ignored and the reverse treasury stock method should be applied in the
same manner as it would if the written put option was not prepaid. If,
however, the prepayment is returned only if the contract expires
unexercised, there is no incremental dilutive effect of the contract,
because the issuing entity will either (1) receive its prepayment back
and no shares will be purchased because the contract expires unexercised
or (2) will not receive back the prepayment but will receive shares of
its own stock. In the first situation, no shares are repurchased and,
accordingly, there is no incremental dilutive impact. In the second
situation, it would be antidilutive to reflect the shares acquired.
4.3.2.1.3 Average Market Price
The same concepts discussed in Section 4.2.2.1.3 regarding the determination of the average market price under the treasury stock method apply under the reverse treasury stock method. Under the reverse treasury stock method, the average market price of the entity’s common stock is used to determine the number of common shares that are assumed to be issued to pay the exercise price or forward price of the contract.
4.3.2.1.3.1 Contracts That Are Issued, Exercised, Forfeited, or Canceled, or That Expire, During a Financial Reporting Period
ASC 260-10-45-26 states, in part, that “[d]ilutive options or warrants that are issued during a period or that expire or are cancelled during a period shall be included in the denominator of diluted EPS for the period that they were outstanding [and] dilutive options or warrants exercised during the period shall be included in the denominator for the period prior to actual exercise.” To meet the ASC 260 requirement under which diluted EPS must include incremental common shares weighted for the period in which a written put option or forward purchase contract was outstanding during a financial reporting period, the average market price used to apply the reverse treasury stock method should reflect an average over the period in which the instrument was outstanding rather than an average over the entire financial reporting period. Thus, for contracts that are issued, exercised, forfeited, or canceled, or that expired, during a financial reporting period, an entity will need to calculate, on an instrument-by-instrument basis, the average market price for the portion of the period in which the instrument was outstanding. The average market price for the entire financial reporting period should not be used to determine the number of common shares that would need to be issued to pay the exercise price or forward price of a contract subject to the reverse treasury stock method if the contract was not outstanding for the entire financial reporting period. The average market price over the entire financial reporting period is used only for instruments that were outstanding for the entire reporting period. See further discussion in Section 4.2.2.1.3.1.
4.3.2.2 Method of Settlement
4.3.2.2.1 General
With one exception, ASC 480 requires an entity to classify written put options
and forward purchase contracts as liabilities (or assets in some
circumstances) and to initially and subsequently measure such contracts at
fair value, with changes in fair value recognized in earnings.14 For written put options and forward purchase contracts, an entity
should first determine whether the reverse treasury stock method should be
applied to calculate diluted EPS. The reverse treasury stock method should
not be applied to contracts that meet any of the following conditions:
-
The contract is a forward purchase contract that is subject to ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3.
-
The contract must be cash-settled (i.e., no common shares are purchased on settlement).
-
The contract is a participating security and the two-class method of calculating diluted EPS is more dilutive than the reverse treasury stock method.
ASC 480-10-45-4 addresses the EPS accounting for a forward contract within the
scope of ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3 (see Section 4.8.4.1.1).
If cash settlement of the contract is required, the reverse treasury stock
method is not applied and no adjustments are made to the numerator or
denominator in the calculation of diluted EPS. Any dilutive impact of the
contract is only reflected through the mark-to-market adjustment recognized
in earnings on the contract through the application of other GAAP.
The reverse treasury stock method is applied in all other circumstances if its
application is dilutive. Other circumstances include (1) the contract must
be share-settled or (2) the issuing entity or the counterparty is permitted
to elect settlement in cash or shares.
Although contracts subject to the reverse treasury stock method must be
classified as liabilities (or assets in some circumstances) for accounting
purposes, it is still assumed that the contract is classified as an equity
instrument under this method of calculating diluted EPS. Therefore, in
addition to the incremental shares that are added to the denominator under
the reverse treasury stock method, an adjustment to the numerator is also
required. The numerator adjustment should reflect the change in net income
that would have occurred during the reporting period if the contract had
been classified in equity. Since contracts subject to the reverse treasury
stock method are typically subsequently measured at fair value, with changes
in fair value recognized in earnings, and contracts classified as equity
instruments are typically not subsequently remeasured, the adjustment to the
numerator will reflect a reversal of the mark-to-market adjustment
recognized on the contract during the reporting period, net of any
associated income tax effects. However, the numerator adjustment should not
be made, and the incremental shares should not be added to the denominator,
if either (1) the contract is a written put option and is out-of-the-money
on the basis of a comparison of the exercise price with the average market
price or (2) the aggregate effect of the two adjustments is antidilutive on
the basis of the antidilution sequencing requirements in ASC 260. See
Section 4.7
for further discussion of the accounting for diluted EPS for contracts
subject to the reverse treasury stock method.
4.3.2.2.2 Contracts That Provide for Net-Share Settlement
Under the reverse treasury stock method, it is assumed that contracts are settled physically or on a “gross” basis (i.e., the entity pays the exercise price or forward price to the counterparty and receives the gross number of common shares underlying the contract). Contracts subject to the reverse treasury stock method often provide for net share or “cashless” settlement. Under a cashless settlement, the entity delivers to the counterparty a number of common shares with a current fair value (or a fair value determined on the basis of an average stock price) equal to the intrinsic value of the contract.
Economically, a net-share settlement of a contract to purchase shares is
equivalent to a physical settlement accompanied by an issuance of shares to
pay the exercise or forward price. However, an entity applying the reverse
treasury stock method must assume that common shares are issued at the
average market price during the financial reporting period; on the other
hand, in a net-share settlement, the number of shares “issued” is based on
the fair value of shares on the settlement date or a weighted-average price
over a specified period that differs from the average market price over the
reporting period. Given the concept of an average market price that must be
applied under ASC 260, contracts that allow for net-share settlement should
be assumed to be exercised on a gross basis, with the dilution calculated
under the reverse treasury stock method.
4.3.2.2.3 Contracts With Multiple Settlement Alternatives
Certain contracts subject to the reverse treasury stock method may offer the
counterparty alternatives related to the consideration that the entity
transfers to it in return for the common shares delivered to the entity. For
example, a counterparty to a put option may be permitted to require the
entity to pay the exercise price in cash or by delivering a debt instrument
of the entity. ASC 260-10-55-8 through 55-11 address the implications
related to the calculation of diluted EPS for contracts with multiple
settlement alternatives. ASC 260-10-55-8 states, in part, that “[w]hen
several conversion alternatives exist, the computation shall give effect to
the alternative that is most advantageous to the holder of the convertible
security.” For contracts that offer the counterparty such alternatives
related to the receipt of the exercise or forward price, the guidance in ASC
260-10-55-8 through 55-11 must be applied to reflect the potential dilutive
impact on diluted EPS. See further discussion in Section 4.6 and Example 4-29.
For certain written put options and forward purchase contracts, the entity may have the right to choose among multiple settlement alternatives, which affect the form of consideration transferred to the counterparty in return for the common shares the entity receives from the counterparty. Since ASC 260-10-55-8 through 55-11 only address settlement alternatives at the option of the counterparty, an entity is not required to apply that guidance when it may elect the settlement alternative. For contracts that give the entity an option regarding the form of consideration it transfers to the counterparty in return for common shares delivered by the counterparty, it is presumed that the entity will act in its best interests since it controls the election. An entity generally would also use this assumption in determining the fair value of the contract and, as discussed in Section 4.3.2.2.1, contracts subject to the reverse treasury stock method are typically measured at fair value.
4.3.3 Examples
Example 4-9
Application of Reverse Treasury Stock Method to Written Put Options — No Mark-to-Market
Adjustment in Period
On January 1, 20X1, Company A issues $100 million of debt securities with detachable put options on its
common stock. Purchasers of each $1,000 note receive 10 put options, giving them the right to require A to
purchase one share of its common stock for $25 per share, the market price of the common stock on the date
the put options are issued. The put options are exercisable at any time during a three-year period beginning
on the issuance date. The average price of A’s common stock during the reporting period ended December 31,
20X2, is $20 per share. For simplicity, assume that there is no mark-to-market adjustment on the written put
options during the reporting period ended December 31, 20X2.
The incremental shares of common stock that A includes in diluted EPS during the reporting period are
calculated as follows:
Example 4-10
Application of Reverse Treasury Stock Method to Written Put Options — Mark-to-Market
Adjustment in Period
Assume the same facts as in the example above, except that during the reporting
period ended December 31, 20X2, the fair value of the
liability for the put options increases from $5 million to
$6.5 million, resulting in a $1.5 million loss that Entity A
recognizes as a mark-to-market adjustment reducing net
income. Assume that A’s tax rate is 25 percent.
On the basis of these facts, in calculating the diluted impact of the put
options under the reverse treasury stock method, A would
need to make an adjustment to increase the numerator (i.e.,
income available to common stockholders) by $1,125,000
($1,500,000 × 75%). This adjustment is required because no
loss would have been recognized on the put options if they
had been classified in equity. Thus, the entity would
consider the $1,125,000 addition to the numerator and the
250,000 addition to the denominator in determining whether
the put options were dilutive during the period in
accordance with the antidilution sequencing requirements of
ASC 260.
Footnotes
13
The reverse treasury stock method does not apply to
purchased options because they are always antidilutive (see Section 4.1.1.1).
14
Forward purchase contracts that must be physically
settled by repurchase of a fixed number of the issuer’s common
shares are subject to the subsequent-measurement and EPS guidance in
ASC 480 (see Section 4.8.4.1.1).
4.4 If-Converted Method
4.4.1 Scope
ASC 260-10
Convertible Securities and the If-Converted Method
45-40 The dilutive effect of
convertible securities shall be reflected in diluted EPS
by application of the if-converted method. . . .
ASC 260-10-45-40 states that the if-converted method applies to convertible
securities. ASC 260-10-20 defines a convertible security as “[a] security that
is convertible into another security based on a conversion rate.” While
convertible debt and preferred securities are the most common types of
convertible securities subject to the if-converted method, this method is not
limited to instruments that allow the counterparty to benefit from increases in
the price of the entity’s common stock. Rather, in accordance with the
definition of convertible security in ASC 260-10-20, the if-converted method
applies to any security that is convertible into another security on the basis
of a conversion rate. Thus, the if-converted method applies to any of the
following securities:
-
Convertible debt securities.
-
Convertible preferred stock.
-
Mandatorily convertible securities.
-
Common stock that is convertible into another class of common stock.
-
Stock-settled debt.
The if-converted method also applies to written call options and forward sale contracts that, upon settlement, cause the counterparty to receive common shares of the entity when either of the following conditions is met:
- The counterparty is required to tender a debt security or preferred security of the entity as payment of the exercise price or forward price.
- The counterparty has the option to pay the exercise price or forward price in either (1) cash or (2) a debt security or preferred security of the entity, and payment of the debt security or preferred security is more advantageous to the counterparty than paying cash. See further discussion in Section 4.6.
There are some exceptions to the application of the if-converted method to the contract types discussed above. Specifically, an entity should not apply the if-converted method to calculate the dilutive impact in the following situations:
- Settlement of conversion for the convertible security is required entirely in cash (i.e., no common shares are issued on settlement of the conversion feature). See Section 4.7 for discussion of contracts settled in cash.
- The two-class method of calculating diluted EPS is more dilutive than the application of the if-converted method to convertible securities that are participating securities. See Section 5.5.4 for discussion of the two-class method of calculating diluted EPS.
Connecting the Dots
The treasury stock method never applies to the calculation of a
convertible security’s impact on diluted EPS. Rather, ASC 260-10-45-40
requires that an entity use the if-converted method to calculate the
dilutive effect of convertible securities. However, for an Instrument C
convertible debt security, the if-converted method is applied in a
manner that produces the same dilution as the treasury stock method.
In the discussion below, it is assumed that the convertible securities are
subject to the if-converted method and do not represent participating
securities. If convertible securities subject to the if-converted method meet
the definition of a participating security, as discussed in Section 5.5.4, an entity
must apply the more dilutive of the if-converted method or the two-class method
of calculating diluted EPS. Chapter 6 includes more detailed discussion of the appropriate
method applied to determine the dilutive effect of different types of
convertible debt securities.
4.4.2 Application of the If-Converted Method
ASC 260-10
Conversion Rate or Exercise Price
45-21 Diluted EPS shall be
based on the most advantageous conversion rate or exercise
price from the standpoint of the security holder. Previously
reported diluted EPS data shall not be retroactively
adjusted for subsequent conversions or subsequent changes in
the market price of the common stock.
Variable
Denominator
45-21A Changes in
an entity’s share price may affect the exercise price of a
financial instrument or the number of shares that would be
used to settle the financial instrument. For example, when
the principal of a convertible debt instrument is required
to be settled in cash but the conversion premium is required
to (or may) be settled in shares, the number of shares to be
included in the diluted EPS denominator is affected by the
entity’s share price. In applying both the treasury stock
method and the if-converted method of calculating diluted
EPS, the average market price shall be used for purposes of
calculating the denominator for diluted EPS when the number
of shares that may be issued is variable, except for
contingently issuable shares within the scope of the
guidance in paragraphs 260-10-45-48 through 45-57. See
paragraphs 260-10-55-4 through 55-5 for implementation
guidance on determining an average market price.
Convertible Securities and the If-Converted Method
The dilutive effect of convertible
securities shall be reflected in diluted EPS by application
of the if-converted method. Under that method:
- If an entity has convertible preferred stock outstanding, the preferred dividends applicable to convertible preferred stock shall be added back to the numerator. The amount of preferred dividends added back will be the amount of preferred dividends for convertible preferred stock deducted from income from continuing operations (and from net income) in computing income available to common stockholders pursuant to paragraph 260-10-45-11.
- If an entity has convertible debt outstanding:1. Interest charges applicable to the convertible debt shall be added back to the numerator. For convertible debt for which the principal is required to be paid in cash, the interest charges shall not be added back to the numerator.2. To the extent nondiscretionary adjustments based on income made during the period would have been computed differently had the interest on convertible debt never been recognized, the numerator shall be appropriately adjusted. Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.3. The numerator shall be adjusted for the income tax effect of (b)(1) and (b)(2).
- The convertible preferred stock or convertible debt shall be assumed to have been converted at the beginning of the period (or at time of issuance, if later), and the resulting common shares shall be included in the denominator. See paragraph 260-10-45-21A if the incremental shares are variable (such as when calculating a conversion premium).
45-41 In applying the if-converted method, conversion shall not be assumed for purposes of computing
diluted EPS if the effect would be antidilutive. Convertible preferred stock is antidilutive whenever the
amount of the dividend declared in or accumulated for the current period per common share obtainable on
conversion exceeds basic EPS. Similarly, convertible debt is antidilutive whenever its interest (net of tax and
nondiscretionary adjustments) per common share obtainable on conversion exceeds basic EPS.
45-42 Dilutive securities that are issued during a period and dilutive convertible securities for which conversion
options lapse, for which preferred stock is redeemed, or for which related debt is extinguished during a period,
shall be included in the denominator of diluted EPS for the period that they were outstanding. Likewise, dilutive
convertible securities converted during a period shall be included in the denominator for the period prior to
actual conversion. The common shares issued upon actual conversion shall be included in the denominator for
the period after the date of conversion. Consequently, shares assumed issued shall be weighted for the period
the convertible securities were outstanding, and common shares actually issued shall be weighted for the
period the shares were outstanding.
4.4.2.1 No Antidilution
ASC 260-10-45-41 prohibits application of the if-converted method, and conversion is not assumed, if the effect of such application would be antidilutive. ASC 260-10-45-41 also provides guidance on how to evaluate whether an individual convertible debt or convertible preferred security would be antidilutive. In addition to determining whether a convertible security is individually antidilutive, an entity must consider the antidilution sequencing requirements (see Section 4.1.2.3).
The determination of whether a convertible security is dilutive to EPS should be
made as of each reporting date. The current fair value of the entity’s
common stock relative to the conversion price of the convertible security is
not relevant to this determination (see Example 4-11). Unlike the treasury
stock method, which applies only to in-the-money written freestanding call
options on common stock, the if-converted method applies to convertible
securities that are out-of-the-money if the effect is dilutive. As a result
of this difference, the if-converted method is often more dilutive than the
treasury stock method. See Chapter 6 for further discussion.
4.4.2.2 Numerator Adjustments
Under the if-converted method, an entity must make various adjustments to the numerator (i.e., income available to common stockholders). Those adjustments include the following, as applicable:
- Convertible debt (including share-settled debt):
-
Interest expense recognized during the period is added back to the numerator (see Section 4.4.2.2.1) unless the principal amount of the convertible debt instrument must be paid in cash (i.e., an Instrument C convertible debt instrument).15
- To the extent that nondiscretionary adjustments were recognized during the financial reporting period and would have been calculated differently if interest on the convertible debt had not been recognized, the numerator should be adjusted (see Section 4.4.2.2.2).
- Any mark-to-market adjustment recognized on the convertible debt instrument should be reversed from the numerator (see Section 4.4.2.2.3).
- Certain gains or losses recognized on actual settlement of the convertible debt instrument should be reversed from the numerator (see Section 4.4.2.2.4).
- An entity should adjust the numerator for the relevant income tax effects of the above items (see Section 4.4.2.2.5).
-
- Convertible preferred stock:
- Dividends that reduced the numerator during the reporting period are added back to the numerator (see Section 4.4.2.2.1.2).
- To the extent that nondiscretionary adjustments were recognized during the financial reporting period and would have been calculated differently if dividends on the convertible preferred stock had not reduced income available to common stockholders, the numerator should be adjusted (see also Section 4.4.2.2.2).
- Any mark-to-market adjustment recognized on the convertible preferred stock instrument should be reversed from the numerator (see also Section 4.4.2.2.3).
- Certain deemed dividends recognized on actual settlement of the convertible preferred stock instrument that reduced net income to arrive at income available to common stockholders should be reversed from the numerator (see Section 4.4.2.2.4).
- The numerator should be adjusted for the relevant income tax effects of the above items (see Section 4.4.2.2.5).
- Common stock convertible or exchangeable into another class of common stock:
- Under the if-converted method, an entity does not typically need to adjust the numerator when common stock is convertible or exchangeable into another class of common stock. Rather, the calculation of diluted EPS for the class of common stock into which the other class is exchangeable or convertible will include the effect of conversion under the if-converted method. However, the two-class method may be more dilutive than the if-converted method. See further discussion in Section 5.5.4.
Connecting the Dots
An entity must take additional considerations into account when its capital structure includes
multiple classes of common stock or participating securities. Even if an entity’s convertible debt
or convertible preferred stock does not meet the definition of a participating security, given
the effect of the if-converted method on the numerator, an entity will be required to reallocate
undistributed earnings among multiple classes of common stock or participating securities
under the two-class method.
If an entity’s convertible debt or convertible preferred stock meets the definition of a
participating security, the if-converted method is applied only if its application is more dilutive
than the two-class method of calculating diluted EPS. When the two-class method of calculating
diluted EPS is more dilutive, an entity may need to reallocate undistributed earnings to the
convertible debt or convertible preferred stock when applying this method. See Chapter 5 for
further discussion of participating securities and the two-class method.
4.4.2.2.1 Interest and Dividends
4.4.2.2.1.1 Capitalized Interest16
ASC 835-20 specifies that the historical cost of acquiring an asset includes the costs necessarily incurred
to bring it to the condition and location necessary for its intended use. If activities necessary to bring an
asset to that condition and location must be performed, the interest costs incurred during that period
as a result of expenditures for the asset are included in the historical cost of acquiring the asset. As
noted in ASC 350-40, interest costs incurred while developing internal-use computer software may be
capitalized in accordance with ASC 835-20. The capitalization of interest costs introduces additional
complexities with respect to calculating the add-back to the numerator related to (1) interest expense
that would not have been recognized had the convertible debt instrument not been outstanding during
the reporting period and (2) capitalized interest that was subsequently recognized in earnings as part of
the subsequent accounting for the qualifying assets.
4.4.2.2.1.1.1 Interest Costs Capitalized During the Reporting Period
Only interest costs that have been expensed during a financial reporting period may be added back to
the numerator during that reporting period. The capitalization of interest costs should not result in any
additional complexity under the if-converted method if an entity either (1) has recognized interest costs
only on convertible debt instruments subject to the if-converted method (e.g., the entity has no other
borrowings outstanding) or (2) has convertible debt instruments subject to the if-converted method
that are associated with specific qualifying assets. The entity will simply add back to the numerator the
interest expense recognized in earnings on its convertible debt (i.e., the portion not capitalized, which
will be readily identifiable) and any related tax effects. However, if an entity has outstanding debt other
than convertible debt and does not associate the convertible debt with specific qualifying assets, the capitalization rate used to calculate the amount of interest costs capitalized into the carrying amount of qualifying assets will reflect a composite rate comprising interest costs incurred on convertible debt and other borrowings not subject to the if-converted method. In this circumstance, the entity will need to consistently apply a systematic and rational method to determine the following amounts:
- The amount of interest costs incurred on convertible debt instruments subject to the if-converted method that was capitalized during the reporting period versus the amount expensed during the reporting period.
- The amount of the interest costs incurred on other borrowings not subject to the if-converted method that was capitalized during the reporting period versus the amount expensed during the reporting period.
Once these amounts are determined, in applying the if-converted method, the entity should add the following three amounts back to the numerator (assuming that the addition of these amounts to the numerator and the common shares included in the denominator is dilutive on the basis of the antidilution sequencing requirements):
- The amount of interest costs incurred during the reporting period on convertible debt instruments subject to the if-converted method that was recognized as an expense.
- The amount of interest costs incurred during the reporting period on other borrowings not subject to the if-converted method that was recognized as an expense but that would have been capitalized if interest costs had not been incurred on convertible debt instruments subject to the if-converted method (i.e., under the assumption that the convertible debt instruments were converted at the beginning of the period or upon issuance if the convertible debt instrument was issued during the period). (This adjustment reflects a nondiscretionary adjustment under the if-converted method.)
- The tax effect of the amounts in the first two bullets.
Entities will generally need to use a “with and without” approach to determine the amounts in the first two bullets above. However, in certain circumstances, an entity may be able to conclude that the total interest costs capitalized would have been unchanged (or would not have been materially different) if the convertible debt instruments subject to the if-converted method had not been outstanding during the reporting period. In these situations, the entity could simply add to the numerator the interest costs incurred on the convertible debt during the reporting period, net of tax.
Connecting the Dots
On the basis of materiality, some entities apply an accounting convention and do not capitalize interest on qualifying assets. In these situations, the amount of interest costs incurred on convertible debt instruments subject to the if-converted method that is added back to the numerator should reflect the amount actually reflected as an expense during the reporting period. Such entities should not perform the calculations described above because it would be inappropriate to add back a hypothetical amount that is calculated as if interest costs on qualifying assets had been capitalized.
4.4.2.2.1.1.2 Capitalized Interest Costs Subsequently Reflected in Earnings
Capitalized interest costs increase the basis of qualifying assets, resulting in
an increase in depreciation expense for assets placed into service,
a decrease in the gain on sale (or increase in loss on sale) for
assets sold, or a decrease in the recognized earnings (or increase
in the recognized losses) for equity method investees. Neither ASC
260 nor ASC 835-20 addresses the treatment of the earnings impact of
capitalized interest costs under the if-converted method. Therefore,
entities should consistently apply one of the following two
approaches as an accounting policy election and provide appropriate
disclosures:
-
Add back to the numerator the amounts of capitalized interest costs reflected in earnings during the reporting period that arose from interest costs capitalized during the reporting period, net of tax.
-
Do not add back to the numerator any amounts of capitalized interest costs that are reflected in earnings during the reporting period.
Although more conceptually pure, the first approach could be extremely complex. Under this approach,
the objective is to add back to the numerator an amount arising from interest costs capitalized during
the reporting period that would not have reduced earnings if the convertible debt instrument had
not been outstanding during the reporting period. As discussed in Section 4.4.2.2.1.1.1, the mere
calculation of the interest cost adjustment to the numerator is complex; this approach adds further
complexity to the if-converted method.
It is not appropriate for an entity to apply an accounting policy under which it
adds back to the numerator amounts that affected earnings during the
reporting period that arose from interest costs capitalized in prior
periods. This type of accounting approach is inconsistent with the
guidance in ASC 260 on nondiscretionary adjustments because the
expense amount that would be added back to the numerator would have
been incurred regardless of whether the convertible debt instrument
was outstanding during the current reporting period. This approach
could also result in counting the same amounts as an “add-back to
the numerator” in multiple reporting periods. Lastly, this approach
is not consistent with ASC 260’s objective that the calculation of
EPS reflect performance based on what has occurred during a
reporting period. Because this approach is not acceptable, the
selection between the two approaches discussed above will generally
not result in material differences because the amount of interest
costs capitalized and subsequently expensed in the same quarterly
reporting period is generally insignificant.
4.4.2.2.1.2 Dividends
As discussed in Section
3.2.2, dividends on preferred stock reduce income
available to common stockholders, or the numerator, in the
calculation of basic EPS. ASC 260-10-45-40(a) states, in part, that
“[t]he amount of preferred dividends added back [to the numerator]
will be the amount of preferred dividends for convertible preferred
stock deducted from income from continuing operations (and from net
income) in computing income available to common stockholders
pursuant to paragraph 260-10-45-11.” Thus, each type of dividend
discussed in Section 3.2.2
that reduced the numerator in the calculation of basic EPS should be
added back to the numerator under the if-converted method. As a
result, such dividends that reduced basic EPS have no impact on the
calculation of diluted EPS. Rather, the dilution of EPS that results
from convertible preferred stock is captured through an assumption
that the common shares issuable on conversion were outstanding
during the reporting period.
Connecting the Dots
As discussed in Section
3.2.2, the application of ASC 260-10-S99-2
and ASC 480-10-S99-3A may result in deemed contributions
during a period. In these circumstances, the amount of the
contributions should be subtracted from income available to
common stockholders under the if-converted method. See
Sections 4.4.2.2.4 and 4.4.2.4.1 for additional considerations
related to situations in which preferred stock is settled
during a reporting period.
4.4.2.2.2 Nondiscretionary Adjustments
ASC 260 states that expenses or charges (other than interest expense on convertible debt) should be added back to the numerator as a nondiscretionary adjustment only if such amounts were “determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.” To meet the definition of a nondiscretionary adjustment, an income statement item must possess both of the following characteristics:
- It is calculated on the basis of net income or loss or a similar measure — Similar measures could include net interest income, interest expense, income available to common stockholders, or EPS. Thus, a nondiscretionary adjustment could potentially arise for convertible preferred stock since the measure is not limited to items that affect an entity’s net income.
- It arises from a contractual right or obligation of the entity — Any amount that does not arise from a contractual right or obligation of the entity is subjective and cannot be considered nondiscretionary.
Since a nondiscretionary adjustment must possess both of the characteristics
described above, the types of nondiscretionary adjustments made under
the if-converted method will be significantly limited in scope. See also
Example
4-14.
Connecting the Dots
ASC 260-10-45-40(b)(2) states that if there are nondiscretionary adjustments that would have been calculated differently if interest expense on the convertible debt had not been recognized, “[t]he numerator shall be appropriately adjusted.” Thus, nondiscretionary adjustments may increase or decrease the numerator. In some cases, a nondiscretionary adjustment may arise from a contract that is recognized at fair value through earnings. In these circumstances, it is appropriate to calculate the fair value adjustment that would have been recognized during the period if interest expense on the convertible debt instrument had not been recognized during the period.
ASC 260-10-45-40(b)(2) does not specifically discuss
situations in which the if-converted method is applied to a convertible
debt instrument for which the principal amount must be paid in cash
(i.e., an Instrument C convertible debt security). However, an entity
should not make any nondiscretionary adjustments in such circumstances
because ASC 260-10-45-40(b)(1) prohibits an entity from adding back
interest charges on such convertible debt instruments to the numerator.
Accordingly, net income or loss for the period would not change and no
nondiscretionary adjustments would therefore be needed.
4.4.2.2.3 Mark-to-Market Adjustments
Except for convertible debt instruments that contain a
separately recognized equity component, an entity may elect the fair value
option and account for convertible debt at fair value, with changes in fair
value recognized in earnings.17 The fair value option is often elected to avoid separation of an
embedded derivative in accordance with ASC 815-15. In other situations, an
entity may separate an embedded conversion option, redemption option, or
other embedded feature from the host debt instrument and account for the
bifurcated derivative at fair value under ASC 815-15.
Accounting for a convertible debt instrument at fair value
under the fair value option, or separating an embedded derivative, does not
obviate the need to apply the if-converted method. However, when a
convertible debt instrument is accounted for at fair value, or the embedded
conversion option or other embedded feature is separated as a derivative,
the mark-to-market adjustment recognized in earnings during the reporting
period must be reversed and treated as an adjustment to the numerator under
the if-converted method. This adjustment is similar to the add-back to the
numerator of interest expense on convertible debt instruments and applies to
all convertible debt instruments and is only made if the combined effect of
the numerator and denominator adjustments is dilutive.
If an entity has the option of settling a conversion of a
convertible debt instrument in cash or stock and (1) the embedded conversion
option has not been separated as an embedded derivative and (2) the fair
value option has not been applied to the instrument, the entity would not
adjust the numerator to reflect a mark-to-market amount that would have been
recognized during a reporting period if the embedded conversion option had
been separated or the fair value had been applied. Rather, the if-converted
method would be applied, if dilutive.
Connecting the Dots
ASC 825-10-45-5 requires entities to “present
separately in other comprehensive income the portion of the total
change in the fair value” of a financial liability that is
recognized at fair value through earnings and that “results from a
change in the instrument-specific credit risk.” Since the credit
component does not enter into the determination of net income, it
should be excluded from the adjustment made to the numerator in the
calculation of diluted EPS. This credit component would only be
included in the adjustment to the numerator if the entity presented
comprehensive income per share.
4.4.2.2.4 Settlement Adjustments
The conversion of a convertible security into common shares in accordance with
the original conversion privileges may affect income available to common
stockholders. The table below discusses some of these types of
situations.
Table 4-6
Conversion Type | Impact on Numerator of Conversion |
---|---|
Convertible debt with a modified embedded
conversion option (i.e., the embedded conversion
option was modified in a transaction not accounted for
as an extinguishment at some point before conversion) | Any remaining unamortized discount arising from the
recognition of the discount on the convertible debt
instrument (i.e., from the amount recognized in equity
resulting from the modification of the convertible debt
instrument) is recognized as interest cost (see Table
6-1). |
Convertible preferred stock with a modified embedded conversion option (i.e., the embedded conversion option was modified in a transaction not accounted for as an extinguishment at some point before conversion) | Any remaining unamortized discount arising from the recognition of the discount
on the convertible preferred stock instrument (i.e.,
from the amount recognized in equity resulting from
the modification of the convertible preferred stock
instrument) is recognized as a dividend on preferred
stock (see Table 3-7). |
Convertible debt with a reclassified embedded conversion option (i.e., the conversion option was reclassified from a derivative liability to equity at some point before conversion) | Any remaining unamortized discount on the convertible debt instrument is recognized as interest cost in accordance with ASC 815-15-40-1. |
Convertible preferred stock with a reclassified embedded conversion option (i.e., the conversion option was reclassified from a derivative liability to equity at some point before conversion) | Any remaining unamortized discount on the convertible preferred stock instrument
is recognized as a dividend on preferred stock (see
Table 3-7). |
Questions often arise regarding how the gains and losses and deemed dividends
discussed in the table above affect the numerator under the if-converted
method. Two views may be considered in such situations:
-
View A — The numerator should be adjusted to include the effect on income available to common stockholders that would have been recognized if all convertible securities outstanding during the reporting period had been converted at the beginning of the reporting period (or the date of issuance, if later). According to this view, provided that the effect is dilutive, an entity would need to calculate one or both of the following:
-
Convertible securities outstanding at the end of the reporting period — The impact on income available to common stockholders that would have been recognized if the convertible securities had been converted at the beginning of the reporting period (or the date of issuance, if later).
-
Convertible securities converted during the reporting period — The incremental impact on income available to common stockholders if the convertible securities had been converted at the beginning of the reporting period (or the date of issuance, if later). In this adjustment, an entity would reflect an increase or decrease to the amount that was recognized in income available to common stockholders, assuming an earlier conversion. To calculate this amount, the entity would need to determine the incremental effect on interest expense or dividends recognized, which could be affected by the discount amortization that was recognized before conversion.
-
-
View B — The numerator should not reflect any impact on income available to common stockholders as a result of assumed conversion at the beginning of the reporting period (or the date of issuance, if later). According to this view, provided that the effect is dilutive, an entity should (1) not adjust the numerator for convertible securities outstanding at the end of the period for any interest expense or dividends that would have been recognized if conversion had occurred at the beginning of the reporting period (or the date of issuance, if later) and (2) reverse from the numerator any interest expense or dividends that was recognized for convertible securities that were converted during the reporting period.
View B is appropriate because it is consistent with ASC 260-10-S99-2 (see
Section
4.4.2.4.1) and the objective of the if-converted method. The
if-converted method is designed to replace the (1) effect on the numerator
when convertible securities are outstanding at any point during a reporting
period with (2) common shares issuable upon conversion. Any interest expense
or deemed dividends that would be recognized, if conversion is assumed, at
the beginning of the period (or the date of issuance, if later) is not
related to an equity transaction; rather, it results from the settlement of
the host debt or preferred stock instrument and therefore should not factor
into the determination of dilution under the if-converted method. Under the
if-converted method, it is assumed that the cost of carrying a convertible
security during a reporting period is fully replaced with the common shares
that holders would own as equity investors during the reporting period. That
is, the holder can participate in the earnings of the entity as either a
holder of a security senior to common stock or as a holder of common stock,
but not both. The interest expense or deemed dividends associated with
conversion of the types of convertible securities referred to in Table 4-6 is
considered participation as an investor in a security other than common
shares.
One could argue View A on the basis that the original guidance that was codified
in ASC 260-10-45-40 was issued before the release of the guidance referred
to in Table 4-6
that requires entities to recognize such amounts upon conversion. Supporters
of View A could also suggest that this view is consistent with (1) the
definition of the if-converted method in the ASC master glossary, which
states that it is “[a] method of computing EPS data that assumes conversion
of convertible securities at the beginning of the reporting period (or at
time of issuance, if later),” and (2) ASC 260-10-45-16, which states, in
part, that “[t]he numerator also is adjusted for any other changes in income
or loss that would result from the assumed conversion of . . . potential
common shares.” However, View A is not required because ASC 260 does not
mandate this approach and the adjustments discussed in ASC 260-10-45-16
pertain to items other than the convertible security that would have had a
different impact on the numerator if the convertible security had not been
outstanding during the reporting period.
4.4.2.2.5 Income Tax Effects
The income tax effects of adjustments to the numerator, if any, that are made under the if-converted
method should be based on the application of ASC 740 and should reflect the marginal tax effect, if
any, of adjustments to the numerator. Depending on the nature of the adjustment, the income tax
consequences could be complex. For example, adjustments to the numerator could affect an entity’s
assessment of whether a valuation allowance should be established or adjusted for deferred tax assets.
For convertible preferred stock instruments, income tax adjustments are often unnecessary because
dividends on preferred stock are generally not deductible.
4.4.2.3 Denominator Adjustments
Under the if-converted method, the denominator includes the common shares issuable upon
conversion of convertible securities. The number of common shares issuable upon conversion of
convertible securities may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence
of a specified event; or (3) a specified rate, price, index, or other variable.
If the number of common shares issuable upon conversion varies only on the basis of the passage of time, the entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any settlement term that will be available to the counterparty at any point during the term the convertible security is outstanding and should assume conversion upon terms that maximize value to the counterparty.
If the number of common shares issuable upon conversion is subject to adjustment
on the basis of the occurrence or nonoccurrence of a specified event that is
not within the counterparty’s control (other than changes in the fair value
of the entity’s stock price), the entity should apply the guidance on
contingently issuable shares to determine the number of common shares
issuable upon conversion. As discussed in Section 4.5, the entity should assume
that the current status of the condition on the reporting date will remain
unchanged (i.e., the specified event will not occur). As a result, potential
adjustment features that are commonly included in the terms of convertible
securities subject to the if-converted method will have no impact on the
application of this method unless and until such adjustment events occur.
Table 4-3
lists common adjustment events that will have no impact on the application
of the if-converted method before the occurrence of the related event.
If the number of common shares issuable upon conversion is linked to a
specified rate, price, index, or other variable, the convertible security is
considered to contain a variable conversion price. If the number of common
shares issuable upon conversion varies solely on the basis of the entity’s
stock price, the entity should apply ASC 260-10-45-21A, which requires that
the entity determine the number of common shares issued on conversion on the
basis of the average market price of the entity’s stock during the reporting
period. (See Example 4-13 for an illustration of this concept.) If, however,
the number of common shares issuable upon conversion varies on the basis of
a specified rate, price, index, or other variable (i.e., it is not based
solely on the entity’s stock price), an entity may apply any of the
following approaches since ASC 260 does not contain specific guidance on
this matter:
-
View A: The number of common shares issuable upon conversion reflects the conversion price at the end of the reporting period — This view is consistent with the guidance on contingently issuable shares in ASC 260. Under that guidance, it is assumed that the contingency (in this case, the conversion price) is resolved as of the end of the reporting period. Thus, an entity calculates the conversion price on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming conversion on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 for additional discussion of the contingently issuable share method.
-
View B: The number of common shares issuable upon conversion is based on the lowest conversion price (highest conversion rate) available to the counterparty during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires that diluted EPS be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the conversion prices applicable for the entire time during the reporting period in which the convertible security was outstanding and should use the conversion price that is least advantageous to the entity and produces the highest number of common shares for the investor. The entity should not project future conversion prices since they will vary on the basis of changes in the rate, price, index, or other variable.
-
View C: The number of common shares issuable upon conversion is based on the average conversion price during the reporting period — This view is consistent with ASC 260-10-45-21A and ASC 260-10-45-23, which require the use of an average.
These three approaches are acceptable regardless of whether the entity or
counterparty controls the timing of conversion (since neither party
ultimately controls the rate, price, index, or other variable that affects
the conversion price). The approach selected is considered an accounting
policy election that must be applied consistently and disclosed.
If the convertible security or any embedded feature in the convertible security is classified as a liability
and recognized at fair value, with changes in fair value reported in earnings, which may be required
because of the variable terms of the contract, an entity must also adjust the numerator in calculating
diluted EPS, as discussed in Section 4.4.2.2.3.
It is not acceptable to determine the conversion price on the basis of the
conversion price at the beginning of the reporting period because there is
no basis in ASC 260 for the use of this approach.
4.4.2.4 Instruments Issued, Redeemed, Converted, or Otherwise Settled During a Financial Reporting Period
If a convertible security is issued, redeemed, converted, or otherwise settled
during a financial reporting period, the dilutive effect of the if-converted
method should be included in the calculation of diluted EPS for the portion of
the period in which the convertible security was outstanding. The incremental
common shares added to the denominator should be weighted for the time
outstanding during the reporting period.
4.4.2.4.1 Redemption or Induced Conversion of Convertible Securities
ASC 260-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: The Effect on the Calculation of Earnings per Share for
a Period That Includes the Redemption or Induced
Conversion of Preferred Stock
S99-2 . . . When a registrant effects a redemption or induced conversion of only a portion of the outstanding
securities of a class of preferred stock, the SEC staff believes that, for the purpose of determining whether
the “if-converted” method is dilutive for the period, the shares redeemed or converted should be considered
separately from the other shares of the same class that are not redeemed or converted. The SEC staff does not
believe that it is appropriate to aggregate securities with different effective dividend yields when determining
whether the “if-converted” method is dilutive, which would be the result if a single, aggregate computation was
made for the entire series of preferred stock.
For example, assume a registrant has 100 shares of convertible preferred stock outstanding at the beginning of
the period. The convertible preferred stock was issued at fair value, which was equal to its par value of $10 per
share, and has a stated dividend of 5 percent, and each share of preferred stock is convertible into 1 share of
common stock. During the period, 20 preferred shares were redeemed by the registrant for $12 per share.
In this example, the SEC staff believes that the registrant should determine whether conversion is dilutive
(1) for 80 of the preferred shares by applying the “if-converted” method from the beginning of the period to
the end of the period using the stated dividend of 5 percent and (2) for 20 of the preferred shares by applying
the “if-converted” method from the beginning of the period to the date of redemption using both the stated
dividend of 5 percent and the $2 per share redemption premium.
Accordingly, assuming that the dividend for the period for the preferred stock was $0.125 per share, a
determination of whether the 20 redeemed shares are dilutive should be made by comparing the $2.125
per-share effect of assuming those shares are not converted to the effect of assuming those 20 shares were
converted into 20 shares of common stock, weighted for the period for which they were outstanding. The
determination of the “if-converted” effect of the 80 shares not redeemed should be made separately, by
comparing the EPS effect of the $0.125 per-share dividend to the effect of assuming conversion into 80 shares
of common stock.
As discussed in the SEC staff’s guidance in ASC 260-10-S99-2, when less than all
shares of a class of convertible preferred stock are redeemed or
converted in accordance with an inducement offer, the unit of account in
the calculation of diluted EPS must be separated into the shares
redeemed or converted and the remaining shares. Such separation results
in the most dilutive calculation, which is consistent with the objective
of diluted EPS. Further, although this issue is not specifically
discussed in the SEC staff guidance above, the same approach should be
applied when a portion of a class of convertible debt instruments is
redeemed or converted in accordance with an inducement offer.
Connecting the Dots
When convertible securities are converted during a reporting period in
accordance with an inducement offer, under the if-converted
method, it is assumed that the securities were converted at the
beginning of the reporting period or on the date of issuance, if
later, on the basis of the stated conversion terms. Because the
numerator adjustment will reflect a reversal of the additional
consideration provided under the inducement offer, the
application of the if-converted method during a period in which
an induced conversion has occurred will typically be
antidilutive for the specific securities that were settled in
accordance with the inducement offer.
4.4.3 Contingently Convertible Instruments
ASC 260-10
Contingently Convertible Instruments
45-43 While the terms of
contingently convertible instruments vary, a typical
instrument includes a market price trigger that exceeds
a specified conversion price of the issuer’s underlying
stock price on the date of issuance by a specified
percentage (for example, 10 percent, 20 percent, or 30
percent). Some contingently convertible instruments have
floating market price triggers for which conversion is
dependent upon the market price of the issuer’s stock
exceeding the conversion price by a specified percentage
or percentages at specified times during the term of the
debt. Other contingently convertible instruments require
that the market price of the issuer’s stock exceed a
specified level for a specified period (for example, 20
percent above the conversion price for a 30-day period).
In addition, contingently convertible instruments may
have additional features such as parity features, issuer
call options, and investor put options.
45-44 Contingently
convertible instruments shall be included in diluted EPS
(if dilutive) regardless of whether the market price
trigger has been met. There is no substantive economic
difference between contingently convertible instruments
and convertible instruments with a market price
conversion premium. The treatment for diluted EPS shall
not differ because of a contingent market price trigger.
The guidance provided in this paragraph also shall be
applied to instruments that have multiple contingencies
if one of the contingencies is a market price trigger
and the instrument is convertible or settleable in
shares based on meeting a market condition — that is,
the conversion is not dependent (or no longer dependent)
on a substantive non-market-based contingency. For
example, this guidance applies if an instrument is
convertible upon meeting a market price trigger or a
substantive non-market-based contingency (for example, a
change in control). Alternatively, if the instrument is
convertible upon achieving both a market price trigger
and a substantive non-market-based contingency, this
guidance would not apply until the non-market-based
contingency has been met. See Example 11 (paragraph
260-10-55-78) for an illustration of this guidance.
ASC 260-10-45-43 and 45-44 address when the if-converted method should be applied to convertible
securities that are contingently convertible into common shares on the basis of a market price trigger or
a market price trigger combined with a non-market-based contingency. Examples of non-market-based
contingencies include an IPO and a change of control. The guidance in ASC 260-10-45-43 and 45-44
applies to all types of convertible instruments subject to the if-converted method. In accordance with
this guidance, as well as the guidance applicable to contingently issuable shares, the application of the
if-converted method to contingently convertible securities is as follows:
- If the instrument becomes convertible only if (1) a specified price of the entity’s common stock (i.e., a market price trigger) is achieved or (2) either a market-price trigger or some other non-market-based contingency is met, the if-converted method should be applied, if dilutive, regardless of whether the contingencies are met.
- If the instrument becomes convertible only if (1) a substantive non-market-based contingency is met or (2) a market price trigger and some other substantive non-market-based contingency are met, the if-converted method should be applied only if the non-market-based contingency has been met. For this purpose, the evaluation of whether the non-market-based contingency has been met should be as of the end of the reporting period. If the non-market-based contingency is met as of the reporting date and application of the if-converted method is dilutive, the dilutive effect should be included in diluted EPS from the beginning of the reporting period or the date of issuance, if later. This approach is consistent with the diluted EPS approach applied to contingently issuable shares (see Section 4.5). See Section 4.9.3 for discussion of application of the if-converted method to the calculation of year-to-date diluted EPS.
If a non-market-based contingency only accelerates the timing of the counterparty’s ability to convert
the instrument into common shares, the non-market-based contingency is ignored and the if-converted
method applies in all periods in which the convertible security is outstanding if the method is dilutive
on the basis of the antidilution sequencing requirements of ASC 260. This situation may exist when a
convertible security is convertible at the holder’s option at or near maturity and contingently convertible
sooner on the basis of a non-market-based contingency.
4.4.4 Examples
Example 4-11
Relevance of Current Fair Value of Common Stock
Company A has issued nonparticipating convertible debt that permits the counterparty to convert the debt
into common stock at a conversion price of $10 per common share. Any conversion must be settled entirely in
common stock. The fair value of A’s common stock as of the date the convertible debt is issued is $8 per share.
At the end of the reporting period, the fair value of A’s common stock is $6 per share and, for the reporting
period, the average market price of A’s common stock is $7. While, economically, a counterparty would not
be expected to convert the debt into common stock at any point during the reporting period, A must apply
the if-converted method in calculating diluted EPS if the effect is dilutive. In performing this assessment, an
entity should first determine whether the interest expense (net of taxes and any discretionary adjustments)
per common share obtainable on conversion is less than basic EPS. If so, the convertible debt instrument
is individually dilutive and the entity must next consider the antidilution sequencing requirements (see
Section 4.1.2.3). If the convertible debt is dilutive in the context of A’s capital structure under the antidilution
sequencing guidance, the if-converted method must be applied in the calculation of diluted EPS even though a
rational investor would not convert the debt instrument.
Example 4-12
Application of If-Converted Method to Outstanding Convertible Preferred Stock and Convertible Debt
Company B, a calendar-year entity, has the following convertible securities outstanding:
- Convertible preferred stock — $1 million of cumulative convertible preferred stock. The convertible preferred stock was originally issued in denominations of $1,000 at the liquidation preference and pays dividends at a rate of 7 percent per annum. The counterparty to the convertible preferred stock can convert the preferred stock into B’s common stock at any time at a conversion price of $5 per $1,000 liquidation value of convertible preferred stock. Settlement in shares of B’s common stock is required for any conversion.
- Convertible debt — $1 million principal amount of convertible debt bearing interest at 12 percent per annum. The convertible debt was originally issued in denominations of $1,000 at the principal amount. The counterparty to the convertible debt can convert the convertible debt at any time at a conversion price of $5 per $1,000 principal amount of convertible debt. Settlement in shares of B’s common stock is required for any conversion.
The convertible preferred stock is outstanding during the entire period. The
convertible debt is issued on July 15. For the year
ended December 31, B’s income available to common
stockholders (after dividends accumulated on the
convertible preferred stock) was $5 million and there
were 10 million weighted-average common shares
outstanding. Company B’s income tax rate is 25 percent.
The average market price of B’s common stock for the
year is $5 per share.
The following table illustrates the calculation of whether the convertible preferred stock is dilutive under the if-converted method:
The convertible preferred stock is dilutive to B’s EPS because the dividends on the preferred stock per common share obtainable on conversion are less than basic EPS.
The following table illustrates the calculation of whether the convertible debt is dilutive under the if-converted method:
The convertible debt is dilutive to B’s EPS because the interest expense (net of tax) per common share
obtainable on conversion is less than basic EPS. In reaching this conclusion, with respect to the potential
common shares added to the denominator, an entity would assume conversion as of the issuance date, which
is later than the beginning of the year. Since the convertible debt has only been outstanding for 5.5 months,
the incremental common shares added to the denominator are weighted for 5.5 months.
Company B’s calculation of diluted EPS for the year ended December 31, which is based on the antidilution
sequencing guidance in ASC 260, is as follows:
The average market price of B’s common stock is not relevant to the calculation of dilution under the
if-converted method.
Example 4-13
Convertible Debt That May Be Settled in Stock or
Cash
On January 1, 20X2, Company S issues $10 million of 10 percent debt that pays
interest that compounds quarterly. On the December 31,
20X5, maturity date, S is required to pay the principal
amount in either cash or common stock. If S elects to
pay the principal amount in shares, it must deliver a
number of shares that has a monetary value equal to the
principal amount as determined on the basis of the
average closing quoted price of S’s common stock over
the 30-day period that ends one business day before the
settlement date.
Company S is calculating diluted EPS for the quarterly period ended March 31,
20X2. The average price of S’s common stock for the
quarterly period ended March 31, 20X2, is $25 per share.
The average price of S’s common stock for the 30-day
period ended March 30, 20X2, is $20 per share. For the
quarterly period ended March 31, 20X2, S has 10 million
weighted-average common shares outstanding and reported
net income of $50 million. Income taxes are ignored in
this example.
The debt obligation meets the definition of a convertible security, and the if-converted method must be applied to determine the dilutive impact because share settlement is presumed. The calculation of basic and diluted EPS for the quarterly period ended March 31, 20X2, is as follows:
*
The number of shares issuable
upon conversion of the debt is determined on the
basis of S’s average share price during the entire
reporting period. This calculation is as follows:
($10,000,000 ÷ $25 = 400,000).
Example 4-14
Bonus as a Nondiscretionary Adjustment
Company D pays an annual bonus to its employees. The amount of the bonus is determined at year-end after
D has closed its books and determined net income for the year before the bonus payment. Historically, D has
paid an aggregate bonus equal to 10 percent of the increase in net income over the prior year. Employees are
aware of this historical practice and expect D to continue it.
The variability in the amount of bonus paid does not represent a nondiscretionary adjustment because the
bonus does not arise from a contractual obligation of D and the amount paid is ultimately subjective. Therefore,
the numerator should not be adjusted to reflect an increased bonus payable if interest on convertible debt did
not reduce net income.
ASC 260-10
Example 11:
Computation of Basic and Diluted EPS for Three
Examples of Contingently Convertible
Instruments
55-78 The following Cases
illustrate the guidance in paragraphs 260-10-45-43
through 45-46 related to diluted EPS computations for
three examples of contingently convertible
instruments:
- Contingently convertible debt with a market price trigger (Case A)
- Contingently convertible debt with a market price trigger, issuer must settle the principal amount of the debt in cash, but may settle any conversion premium in either cash or stock (Case B)
- Convertible debt for which the principal and conversion premium can be settled in any combination of shares or cash (Case C).
55-79
Cases A, B, and C share all of
the following assumptions:
- Principal amount of the convertible debt: $1,000
- Conversion ratio: 20
- Conversion price per share of common stock: $50 Conversion price = (Convertible bond’s principal amount) ÷ (Conversion ratio) = $1,000 ÷ 20 = $50.
- Share price of common stock at issuance: $40
- Market price trigger: average share price for the year must exceed $65 (130% of conversion price)
- Interest rate: 4%
- Effective tax rate: 35%
- Shares of common stock outstanding: 2,000.
Case A: Contingently Convertible Debt With a Market Price Trigger
55-81 The holder of the debt may convert the debt into shares of common stock when the share price exceeds
the market price trigger; otherwise, the holder is only entitled to the par value of the debt.
55-82 The contingently
convertible debt is issued on January 1, 200X, income
available to common shareholders for the year ended
December 31, 200X, is $10,000, and the average share
price for the year is $55. The issuer of the
contingently convertible debt should apply the guidance
in paragraphs 260-10-45-43 through 45-44 which requires
the issuer to include the dilutive effect of the
convertible debt in diluted EPS even though the market
price trigger of $65 has not been met. In this Case,
basic EPS is $5.00. (Basic EPS = [Income available to
common shareholders (IACS)] ÷ [Shares outstanding (SO)]
= $10,000 ÷ 2,000 shares = $5.00 per share) and applying
the if-converted method to the debt instrument dilutes
EPS to $4.96 (Diluted EPS computed using the
if-converted method = [IACS + Interest (1-tax rate)] ÷
(SO + Potential common shares) = ($10,000 + $26) ÷
(2,000 + 20) shares = $4.96 per share.)
Case B: Contingently Convertible Debt With a Market Price Trigger, Issuer Must Settle Principal in Cash, but May Settle Conversion Premium in Either Cash or Stock
55-84 The issuer of the contingently convertible debt must settle the principal amount of the debt in cash upon conversion and it may settle any conversion premium in either cash or stock. The holder of the instrument is only entitled to the conversion premium if the share price exceeds the market price trigger. The contingently convertible instrument is issued on January 1, 200X, income available to common shareholders for the year ended December 31, 200X is $9,980, and the average share price for the year is $64.
55-84A The if-converted
method should be used to determine the
earnings-per-share implications of convertible debt with
the characteristics described in this Case. There would
be no adjustment to the numerator in the diluted
earnings-per-share computation for the cash-settled
portion of the instrument (the principal amount of the
debt) because that portion will always be settled in
cash (see paragraph 260-10-45-40). The conversion
premium should be included in diluted earnings per share
based on the provisions of paragraphs 260-10-45-45
through 45-46 and 260-10-55-32 through 55-36A. The
convertible debt instrument in this Case is subject to
other applicable guidance in Subtopic 260-10 as well,
including the antidilution provisions of that
Subtopic.
55-84B In this Example, basic
EPS is $4.99, and diluted earnings per share is $4.98.
Basic EPS = IACS ÷ SO = $9,980 ÷ 2,000 shares = $4.99
per share. Diluted EPS would be calculated using the
if-converted method by determining the number of shares
needed to settle the conversion premium and adding that
amount to shares outstanding to calculate the diluted
EPS denominator. The average market price is used to
determine the dilution in accordance with paragraph
260-10-45-21A. The effect would be dilutive in this case
because the average market price of the shares exceeds
the conversion price. However, if the average market
price of the shares was less than the conversion price,
then the conversion premium would be zero and there
would be no dilutive effect. Diluted EPS = IACS ÷ (SO +
Potential common shares) = ($9,980) ÷ (2,000 + 4.38)
shares = $4.98 per share. Potential common shares =
(Conversion spread value) ÷ (Average share price) = $14
× 20 shares ÷ $64 = 4.38 shares.
Case C: Convertible Debt That the
Principal and Conversion Premium Can Be Settled in Any
Combination of Shares or Cash
55-84C The issuer of the
convertible debt can settle the principal and the
conversion premium in any combination of cash or shares
(the issuer has the option). Consistent with the facts
in Case B, the convertible instrument is issued on
January 1, 200X, income available to common shareholders
for the year ended December 31, 200X, is $9,980, and the
average share price for the year is $64.
55-84D The if-converted
method should be used to determine the
earnings-per-share implications of convertible debt. The
effect of settling the principal and conversion premium
in shares is included for purposes of calculating
diluted earnings per share in accordance with the
guidance in paragraph 260-10-45-45.
55-84E In this case, basic
EPS is $4.99 (the same calculation in paragraph
260-10-55-84B), and diluted earnings per share is $4.95.
Diluted EPS is calculated using the if-converted method
= [IACS + Interest (1-tax rate)] ÷ (SO + Potential
common shares) = (9,980 + 26) ÷ (2,000 + 20). See
paragraph 260-10-55-82 for interest expense amount.
Footnotes
15
Section
4.4.2.2.1.1 does not apply to
convertible debt instruments for which the
principal amount must be paid in cash.
16
This section does not apply to convertible debt
instruments for which the principal amount must be paid in cash
because interest charges on such instruments are not added back
to the numerator when the if-converted method is applied.
17
ASC 825-10-15-5(f) prohibits the election of the
fair value option for convertible preferred stock that is classified
in stockholders’ equity (whether permanent or temporary equity).
4.5 Contingently Issuable Shares
4.5.1 General
ASC 260-10
Conversion Rate or Exercise Price
45-21 Diluted EPS shall be
based on the most advantageous conversion rate or
exercise price from the standpoint of the security
holder. Previously reported diluted EPS data shall not
be retroactively adjusted for subsequent conversions or
subsequent changes in the market price of the common
stock.
Contingently Issuable Shares
45-48 Shares whose issuance is contingent upon the satisfaction of certain conditions shall be considered outstanding and included in the computation of diluted EPS as follows:
- If all necessary conditions have been satisfied by the end of the period (the events have occurred), those shares shall be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).
- If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive. Those contingently issuable shares shall be included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).
45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the computation of diluted EPS.
45-50 Paragraphs 260-10-45-51 through 45-54 provide general guidelines that shall be applied in determining
the EPS impact of different types of contingencies that may be included in contingent stock agreements.
Contingently issuable shares include common
shares that are issuable for little or no cash consideration when certain
conditions are met, as well as shares of common stock that have been issued and
are subject to return (sometimes referred to as “contingently returnable
shares”).18 Various contingencies may affect the ultimate issuance of common shares.
Typical contingencies underlying contingently issuable share arrangements
include, but are not limited to, one or more of the following:
Neither the mere passage of time nor a condition that is within the counterparty’s control represents
a condition that results in a contingently issuable share arrangement. For share-based payment
arrangements that vest solely on the basis of a service condition, an entity assumes that the requisite
service period will be met for diluted EPS purposes.
Section 3.3.2.5
addresses the impact on basic EPS of contingently issuable shares and indicates
that shares of common stock subject to contingencies are not included in the
denominator of basic EPS until the contingency is resolved. In other words,
shares of common stock are not included in the denominator of basic EPS until
they are no longer contingently issuable. The decision tree below summarizes the
guidance in ASC 260-10-45-48 on when contingently issuable shares are included
in the denominator of diluted EPS. In the decision tree, it is assumed that the
contingent stock agreement was outstanding for the entire reporting period. See
Section 4.5.7
for a comparison between the impact on basic EPS and that on diluted EPS in
contingently issuable share arrangements.
While the concept behind the inclusion of contingently issuable shares in the calculation of diluted EPS may seem straightforward (i.e., the number of common shares that would be issued, if any, should be included in the denominator in the calculation of diluted EPS for a reporting period on the basis of an assumption that the last day of the reporting period was the end of the contingency period), the determination of the number of contingently issuable shares to include in the calculation of diluted EPS can be complex in certain circumstances. In addition, an entity may have contingently issuable potential common shares to which it must apply the treasury stock method or if-converted method if issuance of such potential common shares is assumed on the basis of conditions at the end of the reporting period.
ASC 260-10-45-51 through 45-54 include additional guidance that must be applied to determine the dilutive EPS impact of the following different types of contingencies that may be included in contingent stock agreements:
- Attainment or maintenance of a specified amount of future earnings (see Section 4.5.2).
- Market price of common stock at a future date (see Section 4.5.3).
- Attainment or maintenance of a specified amount of future earnings and market price of common stock at a future date (see Section 4.5.4).
- Discrete events or conditions (see Section 4.5.5).
Contingently issuable share arrangements may also include the contingent issuance of potential common shares. ASC 260-10-45-55 through 45-57 address these types of arrangements. See also Section 4.5.6.
Regardless of the nature of the contingency underlying a contingently issuable share arrangement, if the effect is dilutive, ASC 260-10-45-48(b) requires that entities determine the number of shares that would be issuable (or otherwise included in the denominator) on the basis of an assumption that the last day of the reporting period was the end of the contingency period and that such common shares are included in the denominator of diluted EPS as of the beginning of the financial reporting period
(or as of the date of the contingent stock agreement, if later). Thus, if the arrangement that gives rise
to contingently issuable shares or contingently issuable potential common shares was outstanding
during the entire financial reporting period, the number of additional common shares included in the
denominator in the calculation of diluted EPS is considered to have been outstanding for the entire
financial reporting period. See Section 4.9.4 for additional discussion of the calculation of the number of
contingently issuable shares to include in a year-to-date calculation of diluted EPS.
4.5.1.1 Passage of Time and Events Within Control of Counterparty Are Not Contingencies
An agreement that requires an entity to issue common shares or potential common shares after
the mere passage of time is not considered a contingently issuable share arrangement because the
passage of time is not a contingency. Similarly, an agreement that requires a condition to be met before
common shares or potential common shares are issued is not considered a contingently issuable
share arrangement if the specified condition is within the counterparty’s control. Thus, the guidance on
contingently issuable shares is not applicable and the common shares must be included in diluted EPS,
if they are dilutive, in accordance with the applicable guidance in ASC 260. These types of arrangements
may represent share-based payment arrangements, which are discussed in Section 7.1.2.
An entity may have entered into an arrangement that requires the purchase of outstanding common
shares after the mere passage of time (e.g., on a specified future date). If the common shares are legally
issued and outstanding, they are not considered contingently returnable. Rather, the entity must pay a
purchase price to purchase the common shares and the purchase will occur upon the mere passage
of time. An entity should generally include common shares whose repurchase is contingent on the
passage of time in its calculation of diluted EPS because the shares are currently outstanding and an
assumption that common shares are purchased before the actual consummation of the purchase would
be antidilutive, which is prohibited, as discussed in ASC 260-10-45-17. See Section 4.8.4 for further
discussion of forward contracts to repurchase common shares.
4.5.1.2 No Antidilution
The prohibition on including common shares in the denominator of diluted EPS if the effect would be
antidilutive, as well as the control number and sequencing requirements discussed in Section 4.1.2,
applies to the inclusion of contingently issuable shares in the denominator in the calculation of diluted
EPS. Generally, contingently issuable shares will be antidilutive in the following circumstances:
- When there is a loss within a quarterly financial reporting period, the contingently issuable shares are not included in the calculation of diluted EPS for the quarterly financial reporting period because doing so would be antidilutive. However, the common shares are included in the year-to-date calculation of diluted EPS if there is income on a year-to-date basis and the effect is dilutive. See further discussion in Section 4.9.4.
- The contingently issuable share arrangement involves the issuance of potential common shares (e.g., options or warrants) as opposed to common shares and the effect of assumed exercise or conversion, when the antidilution sequencing requirements of ASC 260 are considered, is antidilutive.
4.5.1.3 Method of Settlement
As discussed in Section
4.7.2, if a contract can be settled in common stock or cash
at the option of the entity or the counterparty, it is always presumed that
it will be settled in common stock. Under ASC 260-10-45-45, any resulting
potential common shares are included in diluted EPS if they are
dilutive.
Contingently issuable share arrangements may be accounted for as liabilities (or
assets in some circumstances). For example, a contingent stock agreement
that represents contingent consideration in a business combination is often
classified as a liability and measured at fair value, with changes in fair
value recognized in earnings. When contingently issuable shares are
accounted for as a liability (or as an asset) at fair value, with changes in
fair value recognized in earnings, an entity must adjust the numerator to
reverse the mark-to-market adjustment recognized in earnings during the
financial reporting period, in addition to including the incremental common
shares in the denominator, if the aggregate effect on the numerator and
denominator is dilutive. See further discussion in Section 4.7.3 and
Example
4-16.
No adjustments would be made to the numerator or denominator for an arrangement
indexed to the issuing entity’s stock that must be settled in cash.
4.5.2 Contingency Based on Future Earnings or Another Performance Measure
4.5.2.1 General
ASC 260-10
Contingently Issuable Shares
45-51 If attainment or maintenance of a specified amount of earnings is the condition and if that amount has been attained, the additional shares shall be considered to be outstanding for the purpose of computing diluted EPS if the effect is dilutive. The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive. Because the amount of earnings may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
Common shares that are contingently issuable on the basis of the attainment or maintenance of future
earnings generally represent contracts with a contingency based on one of the following two types:
- Achieving a specified amount of earnings during a specified period (e.g., achieving a minimum amount of net income during a single year or a minimum amount of aggregate net income over a number of years).
- Achieving a specified level of earnings over a specified period (e.g., achieving an average level of quarterly net income over a single year or an average level of annual net income over a number of years).
While the guidance in ASC 260-10-45-51 is written in the context of the
attainment or maintenance of future earnings, this guidance would also apply
to contingently issuable shares based on the attainment or maintenance of
another performance measure (e.g., revenues, costs or expenses, EBITDA,
operating income).
4.5.2.2 Amount of Future Earnings or Other Performance Measures
Some common shares are contingently issuable on the basis of the attainment of a specified amount
of earnings or another performance measure during a specified period. ASC 260-10-45-51 states that
for these arrangements, “[t]he diluted EPS computation shall include those shares that would be issued
under the conditions of the contract based on the assumption that the current amount of earnings
will remain unchanged until the end of the agreement, but only if the effect would be dilutive” (emphasis
added). Therefore, the number of common shares, if any, to include in the calculation of diluted EPS is
based on the cumulative earnings achieved as of the end of the financial reporting period. Because the
amount of earnings may change in subsequent financial reporting periods, common shares that are
included in the calculation of diluted EPS in a quarterly financial reporting period may be subsequently
excluded from the calculation of diluted EPS in one or more future quarterly financial reporting periods
because of the occurrence of losses in subsequent periods. See Example 4-15 for an illustration of this
concept.
Some contingent stock agreements contain multiple targets related to future earnings or other
performance measures. In some of these arrangements, the counterparty can receive a stated number
of common shares if one of multiple targets is met; in other arrangements, the counterparty is entitled
to a stated number of common shares that varies depending on which targets are met. For example, the
entity may agree to issue additional common shares if more than one target is met. The same guidance
described above applies to these types of arrangements. See Examples 4-16 and 4-17 for more
information. Also see Section 4.5.4 for a discussion of common shares that are contingently issuable
depending on both future earnings and future stock prices.
4.5.2.3 Level of Future Earnings or Other Performance Measures
Common shares may be contingently issuable on the basis of the attainment of a specified level of earnings or another performance measure over a specified period (e.g., an average amount of net income over a three-year period). In such arrangements, an entity must consider several important concepts in ASC 260-10-45-48(b) and ASC 260-10-45-51, including the following:
- “[T]he number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive” (emphasis added).
- “The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive” (emphasis added).
On the basis of this guidance, when common shares are contingently issuable in the future on the basis of the attainment of a specified average level of earnings or another performance measure over a period, an entity must focus on the amount, not the level, achieved as of the end of each financial reporting period (this treatment is similar to that for contingently issuable shares based on an amount of future earnings or another performance measure). In other words, the level of future earnings or another performance measure cannot be projected in the determination of the number of contingently issuable shares, if any, to include in the calculation of diluted EPS. Footnote (f) in Example 3 in ASC 260-10-55-53 through 55-56 states, in part, that “[p]rojecting future earnings levels and including the related contingent shares are not permitted by this Subtopic.”
Therefore, when common shares are contingently issuable in the future on the
basis of the attainment of a specified average level of earnings or another
performance measure, the calculation of the number of shares to be included
in the denominator for diluted EPS, if any, should be based only on the
actual amount of earnings or another performance measure achieved through
the reporting date. In accordance with ASC 260, the entity should assume
that the current amount of earnings or another performance measure will be
unchanged and thus that there are no additional earnings or other
performance measures achieved in the future. An assumption that the current
amount of earnings will remain unchanged would result in an assumption of
zero earnings or other performance measures in the future periods included
in an average calculation. It would not be appropriate for an entity to
assume that the future earnings or another performance measure would be at a
level equal to the most recently reported amount, because such an assumption
would be a projection that the earnings level or other performance measure
will remain unchanged. Such a projection would be inconsistent with ASC 260
since it (1) refers to an assumption that the amount, not the level, will
remain unchanged and (2) specifically prohibits any projection of future
earnings or another performance measure. While the approach applied to
common shares that are contingently issuable on the basis of a level of
earnings or another performance measure over a specified future period is
the same approach applied when the contingency is based on an amount of
future earnings or another financial measure during a specified future
period, the impact on diluted EPS may be significantly different when the
contingency is based on a level of future earnings or another performance
measure. For illustrations, see Examples 4-18 and 7-5.
Note that this guidance does not apply to shares that are contingently issuable on the basis of stock prices. See Section 4.5.3 for more information.
4.5.2.4 Examples
Example 4-15
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings (Single
Earnings Target)
Company X, a calendar-year-end company, purchases Subsidiary Y on January 1, 20X7, for $100 million plus a
commitment to issue 100,000 shares of X’s common stock to the former owners of Y if Y has net income of
$10 million in fiscal year 20X7.
Subsidiary Y reports the following net income (net loss) during the year ended December 31, 20X7:
- Quarter ended March 31, 20X7 — $5 million.
- Quarter ended June 30, 20X7 — $7 million.
- Quarter ended September 30, 20X7 — ($4) million.
- Quarter ended December 31, 20X7 — $17 million.
In determining whether the 100,000 common shares are included in diluted EPS during each financial reporting
period, X must apply ASC 260-10-45-51 and assume that the current amount of earnings achieved to date
remains unchanged until the end of the contingency period. Accordingly, as of the end of each financial
reporting period, X assumes that the cumulative amount of net income does not change (i.e., X produces no
income or loss during the remaining contingency period).
In accordance with ASC 260-10-45-51, X would include the following common shares in the denominator in the
calculations of diluted EPS during each quarterly financial reporting period during the year:
The contingency would not be met if the contingency period ended on the last day of the first quarter (i.e.,
$5 million of net income is less than $10 million), so the contingently issuable shares should not be assumed to
be outstanding for the calculation of diluted EPS for the first quarter ended March 31, 20X7.
The contingency would be met if the contingency period ended on the last day of the second quarter (i.e., X has
reported year-to-date net income of $12 million). Therefore, the 100,000 common shares must be included in
the calculation of diluted EPS for the second quarter ended June 30, 20X7, in accordance with ASC 260-10-45-51,
which requires an assumption that the current amount of earnings will remain unchanged until the end of the
contingency period. The common shares should be considered outstanding for diluted EPS purposes from the
beginning of the quarter.
The contingency would not be met if the contingency period ended on the last day of the third quarter
because, after the net loss reported during the third quarter ended September 30, 20X7, X has cumulatively
generated only $8 million of net income. Therefore, the contingently issuable shares should not be assumed to
be outstanding in the calculation of diluted EPS for the third quarter ended September 30, 20X7.
The contingency would be met if the contingency period ended on the last day of the fourth quarter (i.e., X
has reported year-to-date net income of $25 million), so the 100,000 common shares must be included in the
calculation of diluted EPS for the fourth quarter ended December 31, 20X7. The common shares should be
considered outstanding for diluted EPS purposes from the beginning of the quarter.
See Example 4-34 for an illustration of the common shares included in diluted EPS for the year-to-date
calculations.
Example 4-16
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings (Multiple Earnings Targets)
Company L, a calendar-year-end company, purchases Subsidiary M on January 1, 20X1, for $100 million plus a commitment to issue 100,000 shares of L’s common stock to the former owners of M if M achieves any of the following income targets:
- $100 million of net income in any single calendar year over the three-year period ended December 31, 20X3 (Target 1).
- $175 million of net income over any successive two calendar-year periods over the three-year period ended December 31, 20X3 (Target 2).
- $300 million of net income over the three-year period ended December 31, 20X3 (Target 3).
In addition, if M achieves two of the three targets, an additional 50,000 common shares will be issued.
Company L classifies its obligation to issue the common shares as a liability that is measured at fair value, with changes in fair value recognized in earnings.
For simplicity, this example includes only annual periods. Subsidiary M reports the following net income during each of the three years in the period ended December 31, 20X3:
- Year ended December 31, 20X1 — $95 million.
- Year ended December 31, 20X2 — $80 million.
- Year ended December 31, 20X3 — $125 million.
In determining the common shares issuable under the contingent stock agreement that are included in diluted EPS during each financial reporting period, L must apply ASC 260-10-45-51 and assume that the current amount of earnings achieved to date remains unchanged until the end of the contingency period. Accordingly, as of the end of each financial reporting period, L assumes that the cumulative amount of net income does not change (i.e., no income or loss is produced during the remaining contingency period).
In accordance with ASC 260-10-45-51, L should include the following common shares in the denominator in the calculations of diluted EPS:
The contingency would not be met if the contingency period ended on December 31, 20X1, because none of the three targets are met; thus, the contingently issuable shares should not be assumed to be outstanding for diluted EPS.
The contingency would be met if the contingency period ended on December 31, 20X2 (i.e., M has reported cumulative net income of $175 million, which meets Target 2). Therefore, 100,000 common shares must be included in the calculation of diluted EPS for the year ended December 31, 20X2, in accordance with ASC 260-10-45-51, which requires an assumption that the current amount of earnings will remain unchanged until the end of the contingency period.
The contingency is met as of December 31, 20X3. In fact, both Target 1 and Target 3 are met. Therefore, 150,000 common shares must be included in the denominator in the calculation of diluted EPS for the year ended December 31, 20X3.
In addition to the inclusion of the common shares in the denominator, any mark-to-market adjustment on the obligation related to the issuance of the common shares should be reversed from the numerator. If the combination of that reversal and the outstanding shares included in the denominator is antidilutive, diluted EPS should not reflect the issuance of the common shares or the reversal of the mark-to-market amount reported during the period.
Example 4-17
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings
(Multiple Discrete Earnings Targets)
Company X, which reports on a calendar-year basis, purchases Subsidiary Y on January 1 for $100 million plus
20,000 shares of X’s common stock for each year within the next five years in which Y has net income of
$10 million or more. By June 30 of year 1, Y has net income of $15 million.
The 20,000 shares of X’s common stock would be issuable if the end of the contingency period were June
30 instead of December 31; therefore, the 20,000 common shares should be included in the denominator
of diluted EPS for the three months ending on June 30. The common shares should be included in the
denominator as of the interim period beginning on April 1, which is the beginning of the period in which the
conditions were satisfied. Therefore, the 20,000 shares will be included in the denominator of the calculation of
diluted EPS for the entire three-month interim period ending on June 30. The common shares will be included
in the denominator of diluted EPS for the six months ending on June 30 in accordance with the guidance in ASC
260-10-45-49.
Because there are five separate measurement periods for the contingency, each measurement period in which
a finite number of common shares may be issued should be treated as a separate contingency and evaluated
on the basis of whether X may be required to issue the common shares for each period on a stand-alone basis.
If the purchase agreement requires X to issue 100,000 shares of its common stock if Y achieves $50 million in
cumulative net income at the end of five years, no shares would be included in diluted EPS until the end of the
reporting period for which X has cumulative earnings in excess of $50 million.
For discussion of the impact of the arrangement on basic EPS, see Example
3-29.
Example 4-18
Calculating Diluted EPS When Issuance of Shares Is Contingent on Average Level of Future
Operating Margin
Entity A grants an employee a performance-based restricted stock award on January 1, 20X1, that vests on
December 31, 20X3. According to the terms of the award, the number of shares that will be earned and will
vest depends on A’s three-year average operating margin in accordance with the following schedule:
For the year ended December 31, 20X1, A achieved an operating margin of 40 percent.
In calculating the number of shares to be included in diluted EPS, A should
assume that the operating margin for the years
ending December 31, 20X2, and December 31, 20X3, is
zero. As a result, as of and for the year ended
December 31, 20X1, no contingently issuable shares
should be included in the calculation of diluted EPS
because the average three-year operating margin is
13.33 percent, or (40% + 0 + 0) ÷ 3.
Note that the conclusion would have differed if the contingency was based solely on A’s stock price.
See Section 4.9.4.1 for examples that include quarterly and year-to-date calculations.
4.5.3 Contingency Based on Future Market Price of Common Stock
4.5.3.1 General
ASC 260-10
Contingently Issuable Shares
45-52 The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied.
Common shares may be contingently issuable in the future on the basis of the fair value of the entity’s common stock price. ASC 260-10-45-52 provides the following guidance on how to apply the contingently issuable share method to such arrangements in the calculation of diluted EPS:
- If the number of shares issuable is based on the entity’s common stock price at a specified future date, an entity should use the end-of-period stock price.
- If the number of shares issuable is based on an average of the entity’s common stock price over some future period, an entity should use the average over the same period, with the last day in the average ending on the last day of the reporting period.
The above guidance is consistent with ASC 260’s approach to assuming that the
end of the reporting period is the end of the contingency period.
Share-based payment awards with market conditions are subject to the guidance on contingently issuable shares based on the market price of an entity’s common stock at a future date. See further discussion in Section 7.1.2.3.2.
Connecting the Dots
ASC 260-10-45-21A requires entities to use an
average share price to calculate the impact on diluted EPS of
instruments for which the entity’s share price may affect (1) the
exercise price of the instrument or (2) the number of shares that
may be issued to settle the instrument provided that the arrangement
is not subject to the guidance on contingently issuable shares. It
may be unclear whether an entity should apply the guidance in ASC
260-10-45-48 through 45-57 on contingently issuable shares or the
guidance in ASC 260-10-45-21A on variable denominators. In these
situations, entities must use judgment and there could be diversity
in practice. On the basis of informal discussions with the FASB
staff, we understand that the amendments to ASC 260 made by ASU
2020-06 were not intended to change how entities determine whether
the guidance on contingently issuable shares applies. In those
discussions, the FASB staff acknowledged that the current guidance
in ASC 260 that addresses what constitutes a contingently issuable
share is often difficult to interpret in practice.
4.5.3.2 Examples
Example 4-19
Calculating Diluted EPS When the Issuance of Shares Is Contingent on Future Stock Prices
Company A acquires Company B in a business combination. The purchase price
includes an obligation for A to pay an additional
amount to B if the fair value of A's stock exceeds
$30 on the two-year anniversary of the business
combination. This payment would be equal to the fair
value of 100,000 shares of A's stock on that date.
Company A can meet this obligation by paying the
cash value of 100,000 shares of stock or by issuing
100,000 shares of stock. Assume that this contingent
consideration arrangement is classified as a
liability and measured at fair value, with changes
in fair value recognized in earnings.
The contingently issuable shares related to this arrangement should be included
in diluted EPS if the market price of A’s common
stock at the end of each reporting period exceeds
$30 per share and the adjustment to the numerator to
reverse the period’s mark-to-market impact is
dilutive to EPS. If the market price is $30 per
share or less, the contingent shares should not be
included in diluted EPS and the mark-to-market
adjustment recognized in earnings from the contract
should not be reversed from the numerator in the
calculation of diluted EPS.
Example 4-20
Calculating Diluted EPS When the Issuance of Shares Is Contingent on Future Stock Prices
Company E entered into an option to sell common shares to a counterparty that contains the following key
terms:
- Notional amount — The notional amount depends on the market price of E’s common stock on the exercise date:
- If E’s common stock price is between $25.00 and $29.99, the counterparty can exercise for 10,000 shares.
- If E’s common stock price is between $30.00 and $34.99, the counterparty can exercise for 20,000 shares.
- If E’s common stock price is between $35.00 and $39.99, the counterparty can exercise for 30,000 shares.
- If E’s common stock price is greater than $40.00, the counterparty can exercise for 40,000 shares.
- Exercise price — $25.00 per common share.
This arrangement does not represent a contingently issuable share. Rather, E
should apply the guidance in ASC 260-10-45-21A on
variable denominators to determine the number of
shares issuable under the treasury stock method.
Example 4-21
Calculating Diluted EPS When the Issuance of Shares Is Contingent on Total Shareholder Return
Company T grants an employee a restricted stock award on January 1, 20X1, that vests in three years on a cliff basis (i.e., a three-year service period). The number of shares that vest varies depending on T’s total shareholder return (TSR) over a three-year annualized period, calculated on the basis of the closing price of T’s common stock on December 31, 20X4, and the closing price of T’s common stock on the January 1, 20X1, grant date. It is assumed that dividends declared by T during this three-year period are reinvested. The award is designed to compensate the grantee for providing three years of service to the company; the level of compensation is indexed to T’s performance over that three-year period.
In calculating diluted EPS for the year ended December 31, 20X1, T is considering the following two alternatives related to determining the number of incremental common shares to include in the denominator (note that, for simplicity, the amount of unrecognized compensation cost is ignored in this example):
- Alternative 1 — Include an incremental number of common shares on the basis of the TSR for the year ended December 31, 20X1, under an assumption that the TSR over the three-year annualized period ended December 31, 20X4, will equal the TSR over the annual period ended December 31, 20X1.
- Alternative 2 — Include an incremental number of common shares, if any, on the basis of the TSR for the annual period ended December 31, 20X1, and zero TSR for the remaining two annual periods in the three-year annualized period ending December 31, 20X4. Under this alternative, it is assumed that T’s common stock price does not change from the closing price on December 31, 20X1, and that T does not declare any dividends during the remaining two annual periods. For simplicity purposes, under this approach, T uses the annual TSR for the year ended December 31, 20X1, divided by a factor of 3.
Alternative 2 is consistent with ASC 260. ASC 260-10-45-52 addresses
contingently issuable share arrangements that depend
on the future market price of common stock and
states, in part, that when the number of shares
contingently issuable depends on the market price of
stock at a future date, the “computations of diluted
EPS shall reflect the number of shares that would be
issued based on the current market price at the end
of the period being reported on if the effect is
dilutive.” Although the price of a common share
cannot be less than zero and, therefore, the
approach applied to contingency issuable shares
based on an earnings metric (which can be negative)
sometimes differs from the approach applied to
contingency issuable shares based on stock prices,
the price of T’s common stock as of December 31,
20X4, will most likely be more or less than the
closing price on December 31, 20X1. Alternative 1
would result in a projected growth in T’s common
stock price over the remaining two years in the
vesting period and is thus inconsistent with ASC
260-10-45-52.
Further, ASC 260-10-45-48(b) states, in part, that “[i]f all necessary
conditions have not been satisfied by the end of the
period, the number of contingently issuable shares
included in diluted EPS shall be based on the number
of shares, if any, that would be issuable if the end
of the reporting period were the end of the
contingency period.” While this guidance could be
interpreted as meaning that T should assume that the
award vests on the basis of TSR over a one-year
period (i.e., that the award fully vests at the end
of the first year), such an approach (i.e.,
Alternative 1) is inconsistent with the terms of the
award, which require that three years of service be
performed and that the grantee be compensated for
the return on stock price over a three-year period.
Such an approach would also be inconsistent with the
measurement of compensation cost under ASC 718,
which is based on a market condition reflecting a
three-year period. While Alternative 2 will result
in the inclusion of fewer incremental common shares
than Alternative 1, such an approach is appropriate
and consistent with the prohibition in ASC 260
related to projecting future share prices.
Alternative 2 is also consistent with the approach
in Example 4-18.
Note that if the award’s terms had differed, the conclusion reached could have differed as well. For example, if the award allowed the grantee to terminate service after one year and receive a number of common shares on the basis of TSR for the year ended December 31, 20X1, and that number of incremental common shares exceeded the number that would vest on the basis of the calculation in Alternative 2, the higher incremental number of common shares on the basis of the termination provision should be included in diluted EPS.
4.5.4 Contingency Based on Both Future Earnings or Other Performance Measures and the Future Price of Common Stock
ASC 260-10
Contingently Issuable Shares
45-53 In some cases, the number of shares contingently issuable may depend on both future earnings and
future prices of the shares. In that case, the determination of the number of shares included in diluted EPS
shall be based on both conditions, that is, earnings to date and current market price — as they exist at the end
of each reporting period. If both conditions are not met at the end of the reporting period, no contingently
issuable shares shall be included in diluted EPS.
Common shares may be contingently issuable in the future on the basis of both (1) the attainment of a
specified amount of earnings and (2) the fair value of the entity’s common stock price at a future date.
In these situations, an entity must consider the guidance applicable to each condition to determine the
number of common shares, if any, that would be issuable on the basis of the conditions on the reporting
date.
4.5.5 Discrete Events or Conditions
4.5.5.1 General
ASC 260-10
Contingently Issuable Shares
45-54 If the contingency is based on a condition other than earnings or market price (for example, opening
a certain number of retail stores), the contingent shares shall be included in the computation of diluted EPS
based on the assumption that the current status of the condition will remain unchanged until the end of the
contingency period. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
When the condition underlying the contingent issuance of common shares is the
occurrence or nonoccurrence of a discrete event or condition other than
earnings or market prices, the entity should include the number of common
shares that would be issued, assuming that the current status of the
condition will not change. As with the guidance applicable to earnings and
market price conditions, the number of common shares included in diluted EPS
is based on an assumption that the end of the reporting period is the end of
the contingency period. See Example 4-22 for an illustration of
how the application of the guidance on contingently issuable shares differs
depending on whether the contingency is based on the occurrence or
nonoccurrence of a specified event or condition.
4.5.5.2 Examples
Example 4-22
Treatment in Diluted EPS of Shares Whose Issuance Is Contingent on an
IPO
Company C has issued the following instruments:
- $1 million of preferred stock. The preferred stock pays cash dividends at a stated rate and is mandatorily convertible into common stock if C completes an IPO of its common stock.
- An option that gives its holder the ability to acquire 10,000 shares of C’s common stock at a price per share of $10 and that becomes exercisable in three years if C has not completed an IPO.
If an IPO has not occurred as of the reporting date, the preferred stock should
not affect the denominator in C’s calculation of
basic or diluted EPS. The option would have no
impact on basic EPS since it is not a participating
security. However, if dilutive, the incremental
common shares resulting from the option should be
included in diluted EPS. The option represents a
contingently issuable potential common share. In
accordance with ASC 260-10-45-54, C must assume that
the current status of the condition (i.e., an IPO)
as of the reporting date will remain unchanged until
the end of the contingency period. Accordingly, the
potential common shares resulting from the option
are included in the calculation of diluted EPS, if
dilutive, because it must be assumed that an IPO
will not occur since one has not occurred as of the
reporting date.
If an IPO occurs, C should include
the common shares issued upon mandatory conversion
of the preferred stock in its calculation of basic
EPS on a weighted-average basis, taking into account
the period for which those shares were issued and
outstanding (i.e., C would further adjust diluted
EPS to reflect those common shares as outstanding
from the beginning of the period to the date of the
IPO). The incremental common shares potentially
issuable as a result of the option would not be
included in the calculation of basic or diluted EPS
for the reporting period that includes the IPO
(i.e., as of the end of the reporting period, the
option is no longer exercisable).
Example 4-23
Treatment in Diluted EPS of Shares Whose Issuance Is Contingent on a Favorable Lawsuit
Company X, the claimant in a patent infringement lawsuit, has agreed to issue its external legal counsel 10,000 common shares if it is successful in receiving at least $50 million in damages from the defendant. The receipt of $50 million or more in damages is considered a favorable outcome of the litigation. Company X should treat common shares whose issuance is contingent on the favorable outcome of a lawsuit similarly to how it treats common shares whose issuance is contingent on the attainment of an earnings contingency. That is, the calculation of diluted EPS should include common shares that would be issued in accordance with the conditions of the contingent stock agreement if the amount of current “earnings” remains unchanged until the end of the agreement (only if the effect would be dilutive). The current “earnings” from the lawsuit would be zero. Because the favorable outcome of a lawsuit represents a gain contingency, any “earnings” (i.e., gain) from the lawsuit should be recorded in accordance with ASC 450 and would not be included in diluted EPS until they are realized.
Example 4-24
Treatment in Diluted EPS of Shares Whose Issuance Is Contingent on Continued Employment
Company M has a mandatory deferred compensation plan under which covered employees are required to
defer the amount of compensation payable in one calendar year in excess of $1 million until completion of the
deferral period. The deferral period ends when the employee ceases to earn $1 million annually or reaches the
defined retirement age as an employee of M. If the employee is terminated or resigns, he or she is not eligible
to receive any distribution under the plan. The compensation deferred under the plan is only payable to the
participant in shares of M’s common stock over a five-year period once the participant is eligible to receive the
distribution.
A participant’s deferred compensation is held in an escrow account until the individual is eligible to receive
distributions. The escrow account does not bear interest; however, it receives the dividend equivalent on the
basis of the equivalent number of shares of common stock into which the cash value of the account would be
converted, depending on the closing price of M’s common stock on the NYSE for the trading day preceding the
original deferral. Distributions from the account are based on the equivalent number of shares of common
stock into which the cash value of the distribution would be converted, depending on the closing price of the
stock on the NYSE for the trading day preceding the distribution.
The common stock issuable under the plan is considered contingently issuable because the common stock
will not be issued if the employee is terminated or resigns from M’s employment before retirement. The
shares issuable under the plan should be included in the calculation of diluted EPS as of the reporting date
for participants that continue to be employed under the assumption that the end of the reporting period is
the end of the contingency period (i.e., the participant has not been terminated and has not resigned before
retirement and therefore would be entitled to amounts in his or her account). Since the number of contingently
issuable shares depends on the market price of M’s common stock, the number of common shares included in
the denominator of diluted EPS should be based on M’s common stock price at the end of the reporting period
in accordance with ASC 260-10-45-52.
For an illustration of the impact of the arrangement on basic EPS, see Example
3-30.
4.5.6 Contingently Issuable Potential Common Shares
ASC 260-10
Contingently Issuable Shares
45-55 Contingently issuable potential common shares (other than those covered by a contingent stock
agreement, such as contingently issuable convertible securities) shall be included in diluted EPS as follows:
- An entity shall determine whether the potential common shares may be assumed to be issuable based on the conditions specified for their issuance pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-54.
- If those potential common shares should be reflected in diluted EPS, an entity shall determine their impact on the computation of diluted EPS by following the provisions for options and warrants in paragraphs 260-10-45-22 through 45-37, the provisions for convertible securities in paragraphs 260-10- 45-40 through 45-42, and the provisions for contracts that may be settled in stock or cash in paragraph 260-10-45-45, as appropriate.
45-56 Neither interest nor dividends shall be imputed for the additional contingently issuable convertible
securities because any imputed amount would be reversed by the if-converted adjustments for assumed
conversions.
45-57 However, exercise or conversion shall not be assumed for purposes of computing diluted EPS unless
exercise or conversion of similar outstanding potential common shares that are not contingently issuable is
assumed. See Example 3 (paragraph 260-10-55-53) for an illustration of this guidance.
An entity may be party to contingently issuable potential common shares (e.g., written call options to sell common stock) that become exercisable only if a contingent event occurs. For these types of arrangements, an entity should apply the guidance in ASC 260-10-45-48 through 45-54 to determine whether the potential common shares should be assumed to be issuable and, if so, the entity should use the appropriate method to determine the dilutive impact, if any, of the potential common shares. If the arrangement represents contingently convertible debt, see Section 4.4.3.
If an entity has issued potential common shares for which a contingency only
affects the terms of the instrument (e.g., a contingency only affects the
exercise price or the number of common shares), the contingency will only
potentially affect the terms that are used to apply the appropriate method for
calculating the dilutive impact, if any, of such an instrument. See further
discussion in Sections
4.2.2.1.1, 4.2.2.1.2.1, 4.3.2.1.1, 4.3.2.1.2.1, and 4.4.2.3.
See Section 7.1.2.3
for discussion of the accounting for diluted EPS for share-based payment awards
with performance or market conditions.
4.5.7 Summary of Treatment of Contingently Issuable Shares in Basic and Diluted EPS
The graphic below summarizes the treatment of contingently issuable shares in the denominator in the calculations of basic and diluted EPS.
Footnotes
18
Outstanding common shares that are contingently
returnable (i.e., subject to recall) are treated in the same manner as
contingently issuable shares in the calculation of diluted EPS. Thus,
whether the shares have been issued to the counterparty is not relevant.
See Section
7.1.1 for discussion of the impact of clawback features
on share-based payment awards.
4.6 Contracts With Multiple Settlement Alternatives
4.6.1 General
ASC 260-10
Options and Warrants and Their Equivalents
55-7 Paragraphs 260-10-55-9
through 55-11 provide guidance on how certain
options and warrants should be included in the
computation of diluted EPS. Exercise of the
potential common shares discussed in those
paragraphs shall not be reflected in diluted EPS
unless the effect is dilutive. Those potential
common shares will have a dilutive effect if
either of the following conditions is met:
- The average market price of the related common stock for the period exceeds the exercise price.
- The security to be tendered is selling at a price below that at which it may be tendered under the option or warrant agreement and the resulting discount is sufficient to establish an effective exercise price below the market price of the common stock obtainable upon exercise.
55-8 When several conversion
alternatives exist, the computation shall give effect to
the alternative that is most advantageous to the holder
of the convertible security. Similar treatment shall be
given to preferred stock that has similar provisions or
to other securities that have conversion options that
permit the investor to pay cash for a more favorable
conversion rate.
55-9 Options or warrants may
permit or require the tendering of debt or other
securities of the issuer (or its parent or its
subsidiary) in payment of all or a portion of the
exercise price. In computing diluted EPS, those options
or warrants shall be assumed to be exercised and the
debt or other securities shall be assumed to be
tendered. If tendering cash would be more advantageous
to the option holder or warrant holder and the contract
permits tendering cash, the treasury stock method shall
be applied. Interest (net of tax) on any debt assumed to
be tendered shall be added back as an adjustment to the
numerator. The numerator also shall be adjusted for any
nondiscretionary adjustments based on income (net of
tax). The treasury stock method shall be applied for
proceeds assumed to be received in cash.
55-10 The underlying terms of certain options or warrants may require that the proceeds received from
the exercise of those securities be applied to retire debt or other securities of the issuer (or its parent or its
subsidiary). In computing diluted EPS, those options or warrants shall be assumed to be exercised and the
proceeds applied to purchase the debt at its average market price rather than to purchase common stock
under the treasury stock method. The treasury stock method shall be applied, however, for excess proceeds
received from the assumed exercise. Interest, net of tax, on any debt assumed to be purchased shall be added
back as an adjustment to the numerator. The numerator also shall be adjusted for any nondiscretionary
adjustments based on income (net of tax).
55-11 Convertible securities
that permit or require the payment of cash by the holder
of the security at conversion are considered the
equivalent of warrants. In computing diluted EPS, the
proceeds assumed to be received shall be assumed to be
applied to purchase common stock under the treasury
stock method and the convertible security shall be
assumed to be converted under the if-converted method.
See Example 11 (paragraph 260-10-55-78) for guidance on
the effects of contingently convertible instruments on
diluted EPS.
Certain contracts offer the counterparty conversion or settlement alternatives related to how the
contract will be settled. ASC 260-10-55-7 through 55-11 address how to calculate the dilutive impact of
certain contracts that offer the counterparty conversion or settlement alternatives, as well as certain
contracts that require the entity to use the proceeds to retire debt or other securities. This guidance
requires an entity to assume the conversion or settlement alternative that is most advantageous to the
counterparty in calculating diluted EPS. In doing so, the entity may apply the treasury stock method, the
if-converted method, or a combination of both.
ASC 260-10-55-10 indicates that if “[t]he underlying terms of certain options or warrants . . . require that the proceeds received from [exercise] be applied to retire debt or other securities of the issuer,” an entity must assume, in computing diluted EPS, that the proceeds from the assumed exercise of those options or warrants are “applied to purchase the debt [or other securities of the issuer] at its average market price rather than to purchase common stock under the treasury stock method.” Note that this guidance applies only when the underlying terms of the options or warrants dictate how the issuer must use the proceeds. It does not apply if the terms or provisions of other arrangements involving the issuer (e.g., debt covenants) require the issuer to use the proceeds from the exercise of such options or warrants to repay outstanding indebtedness. Rather, in those circumstances, the treasury stock method should be applied without alteration. That is, the entity should assume that the proceeds are used to repurchase its common shares at the average market price during the period and should not adjust the numerator to reverse interest expense on the issuer’s debt.
ASC 260-10-55-11 indicates that if a holder of a convertible security is required to both tender the security and pay cash to convert the security into common stock, when conversion is dilutive, the proceeds to be received upon exercise should be assumed to be used to purchase common stock under the treasury stock method and the convertible security should be assumed to be converted under the if-converted method. A holder of a convertible security may be permitted, but not required, to both tender the security and pay cash to convert the security into common stock. That is, the holder is entitled to either (1) tender the convertible security in return for a fixed or determinable number of common shares or (2) tender the convertible security and pay cash in return for a stated number of common shares that exceeds the number of common shares receivable under the first alternative. In these circumstances, diluted EPS should be calculated on the basis of the alternative that is most advantageous to the holder of the security in accordance with ASC 260-10-55-8.
4.6.2 Examples
Example 4-25
Option That Permits Tendering of an Entity’s Preferred Stock as Payment of Exercise Price
Company A issues 1,000 options that, if exercised, permit the counterparty to elect to tender either a share of the $2,750 face value of A’s outstanding preferred stock or $2,500 in exchange for 100 common shares. The preferred stock pays dividends at 10 percent annually. On the date the option is issued, the common stock of A is trading at $25 per share. The following year, A has $20 million in income from continuing operations and weighted-average shares outstanding of 8 million, and the common stock has an average market price of $40 per share. Assume that the preferred stock has a market price of $2,600 as of the date A is calculating diluted EPS.
In applying the treasury stock method, because the options are in-the-money, A should assume that the counterparty will elect to exercise its option and pay $2,500 in cash rather than tendering preferred stock that has a market price of $2,600. Because the exercise of the option would dilute EPS, the treasury stock method, as described in ASC 260-10-55-9, should be applied to calculate the incremental dilutive shares as follows:
Example 4-26
Option That Requires Tendering of the Issuer’s Preferred Stock as Payment of Exercise Price
Company B issues 1,000 options that, if exercised, require the counterparty to tender a share of the $2,750
face value of B’s outstanding preferred stock in exchange for 500 shares of common stock. On the date the
option is issued, B’s common stock is trading at $5 per share. The preferred stock pays dividends at 10 percent
annually. The following year, B has $15 million in income from continuing operations, weighted-average shares
outstanding of 4 million, and an average market price of common stock of $15 per share. Assume that the
preferred stock has a market price of $2,750 as of the date B is calculating diluted EPS.
In calculating diluted EPS, B must apply the if-converted method because the options are in-the-money and
require the counterparty to tender preferred stock as payment of the exercise price. The following table shows
B’s calculations of basic and diluted EPS for the period:
Example 4-27
Option That Requires Application of Proceeds From Exercise to Retire an Entity’s Preferred Stock
Company C issues 400,000 options to purchase common stock at $40 per share, which, if exercised, require
C to retire with the proceeds 1,000 shares of preferred stock with a face value of $2,750. The preferred stock
pays dividends at 10 percent annually. Company C has income from continuing operations of $15 million,
weighted-average shares outstanding of 4 million, and an average market price of common stock of $50 per
share. The average fair value of the preferred stock is $2,800.
Because the options are in-the-money, the treasury stock method described in ASC 260-10-55-10 must be applied to C’s calculation of diluted EPS. The following table illustrates C’s calculation of diluted EPS for the period:
Example 4-28
Convertible Securities That Permit Payment of Cash at Conversion
Company D issues 10,000 convertible bonds with a face value of $1,000 that allow the counterparty to pay
$200 in cash and surrender the bond for 40 shares of common stock. The convertible bonds pay interest at
10 percent annually. Company D has income from continuing operations of $15 million, weighted-average
shares outstanding of 4 million, and an average market price of common stock of $50 per share.
Exercise of the convertible bonds is dilutive; therefore, under the combination
of the if-converted and treasury stock method, as
described in ASC 260-10-55-11, D should assume
that the counterparties would elect conversion.
The impact on diluted EPS is calculated as follows
(income taxes are ignored):
Example 4-29
Application of Reverse Treasury Stock Method to Written Put Option With Multiple Settlement
Alternatives
Company E enters into a written put option that allows the counterparty to sell 10,000 common shares to E at
$20 per share. The written put option must be physically settled. Upon exercise, the counterparty is permitted
to require E to deliver either $200,000 in cash or a $200,000 principal amount of 7.5 percent debt issued by E.
Company E is required to classify the put option as a liability and measure it at fair value, with changes in fair
value recognized in earnings. Thus, in calculating diluted EPS, E must also consider the numerator adjustment
that is required (see Section 4.7.3).
In the determination of whether the put option is dilutive to E’s EPS and to
calculate diluted EPS under the reverse treasury
stock method, an additional consideration is
necessary because the counterparty has an option
to elect to require E to deliver a debt instrument
in lieu of cash, which results in a variable
exercise price. If the fair value of the debt
instrument exceeds $200,000, the counterparty
would elect to require E to deliver the debt
instrument rather than cash. As a result, for each
financial reporting period for which E calculates
diluted EPS, it must consider whether it is more
advantageous for the counterparty to receive the
debt instrument or cash. This assessment is based
on a comparison of $200,000 with the fair value of
the debt instrument as of the end of the reporting
period, which is consistent with View A in
Section 4.3.2.1.2.1.
If the fair value of the debt instrument is less than $200,000, the counterparty would elect to receive cash on exercise of the put option and the reverse treasury stock method should be applied under the assumption that E is required to deliver $200,000 in return for 10,000 common shares. If the fair value of the debt instrument exceeds $200,000, the counterparty would elect to receive the debt instrument on exercise of the put option. Accordingly, E will be required to calculate an effective exercise price of the put option to determine whether the put option is in-the-money from the counterparty’s perspective and, if so, the dilutive impact. Below are four different scenarios related to the average market price of E’s common stock and the fair value of the debt instrument. These scenarios illustrate the application of ASC 260-10-55-7 through 55-10.
Scenario 1 — Average Market Price of E’s Common Stock Is $22; Fair Value of Debt Instrument Is $175,000
Because the fair value of the debt instrument is less than the cash amount the
counterparty may receive upon exercise, it is
assumed that the counterparty would elect to
receive cash on exercise of the put option. When
only the cash exercise price per share and the
average market price of E’s common stock during
the period are considered, the put option is
out-of-the-money from the counterparty’s
perspective; therefore, the reverse treasury stock
method does not apply to E’s calculation of
diluted EPS.
Scenario 2 — Average Market Price of E’s Common Stock Is $22; Fair Value of Debt Instrument Is $225,000
Because the fair value of the debt instrument exceeds the cash amount the counterparty may receive upon exercise, it is assumed that the counterparty would elect to receive the debt instrument on exercise of the put option; therefore, an effective exercise price must be calculated. The effective exercise price is $22.50 per share ($225,000 ÷ 10,000 shares = $22.50). When the effective exercise price per share and the average market price of E’s common stock during the period are considered, the put option is in-the-money from the counterparty’s perspective; therefore, the reverse treasury stock method applies to E’s calculation of diluted EPS if the incremental shares and any numerator adjustment associated with mark-to-market adjustments recognized during the period on the put option are dilutive under the antidilution sequencing requirements of ASC 260.
Scenario 3 — Average Market Price of E’s Common Stock Is $18; Fair Value of Debt Instrument Is $175,000
Because the fair value of the debt instrument is less than the cash amount the counterparty may receive upon exercise, it is assumed that the counterparty would elect to receive cash on exercise of the put option. When only the cash exercise price per share and the average market price of E’s common stock during the period are considered, the put option is in-the-money from the counterparty’s perspective; therefore, the reverse treasury stock method applies to E’s calculation of diluted EPS, if the incremental shares and any numerator adjustment associated with mark-to-market adjustments recognized during the period on the written put option are dilutive under the antidilution sequencing requirements of ASC 260.
Scenario 4 — Average Market Price of E’s Common Stock Is $18; Fair Value of Debt Instrument Is $225,000
Because the fair value of the debt instrument exceeds the cash amount the counterparty may receive upon exercise, it is assumed that the counterparty would elect to receive the debt instrument on exercise of the put option; therefore, an effective exercise price must be calculated. The effective exercise price is $22.50 per share ($225,000 ÷ 10,000 shares = $22.50). When the effective exercise price per share and the average market price of E’s common stock during the period are considered, the put option is in-the-money from the counterparty’s perspective; therefore, the reverse treasury stock method applies to E’s calculation of diluted EPS, if the incremental shares and any numerator adjustment associated with mark-to-market adjustments recognized during the period on the put option are dilutive under the antidilution sequencing requirements of ASC 260.
The calculations under the reverse treasury stock method (any numerator adjustments are ignored) are as
follows:
4.7 Contracts That May Be Settled in Stock or Cash
4.7.1 General
ASC 260-10
Contracts That May Be Settled in Stock or Cash
45-45 The effect of potential share settlement shall
be included in the diluted EPS calculation (if the effect is more dilutive)
for an otherwise cash-settleable instrument that contains a provision that
requires or permits share settlement (regardless of whether the election is at
the option of an entity or the holder, or the entity has a history or policy
of cash settlement). An example of such a contract accounted for in accordance
with this paragraph and paragraph 260-10-45-46 is a written call option that
gives the holder a choice of settling in common stock or in cash. An election
to share settle an instrument, for purposes of applying the guidance in this
paragraph, does not include circumstances in which share settlement is
contingent upon the occurrence of a specified event or circumstance (such as
contingently issuable shares). In those circumstances (other than if the
contingency is an entity’s own share price), the guidance on contingently
issuable shares should first be applied, and, if the contingency would be
considered met, then the guidance in this paragraph should be applied.
Share-based payment arrangements that are payable in common stock or in cash
at the election of either the entity or the grantee shall be accounted for
pursuant to this paragraph and paragraph 260-10-45-46, unless the share-based
payment arrangement is classified as a liability because of the requirements
in paragraph 718-10-25-15 (see paragraph 260-10-45-45A for guidance for those
instruments). If the payment of cash is required only upon the final
liquidation of an entity, then the entity shall include the effect of
potential share settlement in the diluted EPS calculation until the
liquidation occurs.
45-45A For a share-based payment
arrangement that is classified as a liability because of the requirements in
paragraph 718-10-25-15 and may be settled in common stock or in cash at the
election of either the entity or the holder, determining whether that contract
shall be reflected in the computation of diluted EPS shall be prepared on the
basis of the facts available each period. It shall be presumed that the
contract will be settled in common stock and the resulting potential common
shares included in diluted EPS (in accordance with the relevant guidance of
this Topic) if the effect is more dilutive. The presumption that the contract
will be settled in common stock may be overcome if past experience or a stated
policy provides a reasonable basis to conclude that the contract will be paid
partially or wholly in cash.
45-46 A contract that is
reported as an asset or liability for accounting purposes may require an
adjustment to the numerator for any changes in income or loss that would
result if the contract had been reported as an equity instrument for
accounting purposes during the period. That adjustment is similar to the
adjustments required for convertible debt in paragraph 260-10-45-40(b).
45-47 Paragraphs 260-10-55-32
through 55-36A provide additional guidance on contracts that may be settled in
stock or cash.
Contracts That May Be Settled in
Stock or Cash
55-32 Adjustments shall be made
to the numerator for contracts that are asset or liability classified, in
accordance with Section 815-40-25, but for which the potential common shares
are included in the denominator in accordance with the guidance in paragraph
260-10-45-45. For purposes of computing diluted EPS, the adjustments to the
numerator are only permitted for instruments for which the effect on net
income (the numerator) is different depending on whether the instrument is
accounted for as an equity instrument or as an asset or liability (for
example, those that are within the scope of Subtopics 480-10 and 815-40).
ASC 260-10-45-45 and 45-46 and ASC 260-10-55-32 contain the following two important concepts that must be considered for certain contracts regardless of the method used to calculate diluted EPS:
- Contracts that provide for settlement in cash — When a contract may be settled in cash or common stock, an entity must assume share settlement when accounting for diluted EPS unless the arrangement is within the scope of the guidance in ASC 260-10-45-45A that addresses certain share-based payment awards.
- Classification of contract for accounting purposes — An adjustment to the numerator is required for contracts that are classified as an asset or liability for accounting purposes but are treated as share-settled for diluted EPS. The adjustment to the numerator results in a consistent treatment of the classification of the contract and the accounting for diluted EPS. No adjustment would be made to the numerator for an equity-classified contract. That is, for a freestanding equity-classified contract, the entity would never adjust the numerator for the mark-to-market adjustment that would have been recognized if the contract had been classified as an asset or liability even if doing so would be dilutive. Rather, the effect of such a contract on diluted EPS is only reflected in the denominator by using the appropriate method (e.g., the treasury stock method).
Connecting the Dots
ASC 260 does not address whether an entity can assume cash
settlement for contracts that the entity is permitted to settle in shares but for
which such settlement would be uneconomical (e.g., the entity can pay $1 million in
cash or $2 million in shares). In certain circumstances, it may be acceptable for an
entity not to assume share settlement for diluted EPS purposes when doing so would
reflect a settlement alternative that would never occur because it would be
uneconomical. However, to conclude that share settlement is uneconomical, an entity
would need to carefully consider the facts and circumstances and may have to use
significant judgment. The entity may, for instance, need to support this conclusion by
looking to the terms of the contract rather than to its intentions, expectations, or
other entity-specific considerations. Entities are strongly encouraged to consult with
their advisers in these circumstances.
4.7.2 Contracts That Provide for Settlement in Cash
4.7.2.1 General
ASC 260-10
Contracts That May Be Settled in Stock or Cash
45-45 The effect of potential share settlement
shall be included in the diluted EPS calculation (if the effect is more
dilutive) for an otherwise cash-settleable instrument that contains a
provision that requires or permits share settlement (regardless of whether
the election is at the option of an entity or the holder, or the entity has
a history or policy of cash settlement). An example of such a contract
accounted for in accordance with this paragraph and paragraph 260-10-45-46
is a written call option that gives the holder a choice of settling in
common stock or in cash. An election to share settle an instrument, for
purposes of applying the guidance in this paragraph, does not include
circumstances in which share settlement is contingent upon the occurrence of
a specified event or circumstance (such as contingently issuable shares). In
those circumstances (other than if the contingency is an entity’s own share
price), the guidance on contingently issuable shares should first be
applied, and, if the contingency would be considered met, then the guidance
in this paragraph should be applied. Share-based payment arrangements that
are payable in common stock or in cash at the election of either the entity
or the grantee shall be accounted for pursuant to this paragraph and
paragraph 260-10-45-46, unless the share-based payment arrangement is
classified as a liability because of the requirements in paragraph
718-10-25-15 (see paragraph 260-10-45-45A for guidance for those
instruments). If the payment of cash is required only upon the final
liquidation of an entity, then the entity shall include the effect of
potential share settlement in the diluted EPS calculation until the
liquidation occurs.
45-45A For a share-based payment
arrangement that is classified as a liability because of the requirements in
paragraph 718-10-25-15 and may be settled in common stock or in cash at the
election of either the entity or the holder, determining whether that
contract shall be reflected in the computation of diluted EPS shall be
prepared on the basis of the facts available each period. It shall be
presumed that the contract will be settled in common stock and the resulting
potential common shares included in diluted EPS (in accordance with the
relevant guidance of this Topic) if the effect is more dilutive. The
presumption that the contract will be settled in common stock may be
overcome if past experience or a stated policy provides a reasonable basis
to conclude that the contract will be paid partially or wholly in cash.
45-46 A contract that is reported as an asset or
liability for accounting purposes may require an adjustment to the numerator
for any changes in income or loss that would result if the contract had been
reported as an equity instrument for accounting purposes during the period.
That adjustment is similar to the adjustments required for convertible debt
in paragraph 260-10-45-40(b).
45-47 Paragraphs 260-10-55-32 through 55-36A provide additional guidance on contracts that may be settled
in stock or cash.
Contracts That May Be Settled in Stock or Cash
55-33 The references in paragraphs 260-10-45-30 and
260-10-45-45 for share-based payment arrangements that are payable in common
stock or in cash at the election of either the entity or the grantee refer
to using the guidance in paragraph 260-10-45-45A for purposes of determining
whether shares issuable in accordance with such plans are included in the
denominator for purposes of computing diluted EPS amounts. Accordingly, the
numerator is not adjusted in those circumstances. Paragraph 260-10-55-36A
illustrates these requirements.
Certain contracts indexed to an entity’s common stock must be settled in cash.
Other contracts allow the entity or the counterparty to choose among one or more of
net-cash settlement, net-share settlement, or physical settlement. While the guidance in
ASC 260 only refers to settlement in cash or stock, the same considerations apply to a
contract that allows for settlement in cash or potential common stock (e.g., a warrant
on a convertible security that may be settled in cash or by delivery of the convertible
security).
4.7.2.2 Contract Must Be Settled in Cash
A contract indexed to an entity’s common stock that must be net-cash-settled is classified as an asset or a liability for accounting purposes. Since the contract will not result in delivery of common shares, no incremental common shares should be added to the denominator in the calculation of diluted EPS. Any amounts reported in net earnings during a financial reporting period on the contract may not be reversed from the numerator in the calculation of diluted EPS.
4.7.2.3 Entity or Counterparty Controls Form of Settlement
When the entity controls the form of consideration upon settlement of
a contract, the accounting for diluted EPS is determined on the basis of share
settlement and the resulting potential common shares are included in diluted EPS if they
are dilutive.19 The same is true if the counterparty controls the form of consideration upon
settlement of a contract. That is, share settlement is always applied in the calculation
of diluted EPS unless the guidance in ASC 260-10-45-45A applies. If the contract is
classified as an asset or liability, the entity must both (1) adjust the numerator to
reflect the accounting as an equity instrument and (2) apply the appropriate method of
calculating diluted EPS to the contract (i.e., the treasury stock method, reverse
treasury stock method, if-converted method, or contingently issuable share method) to
determine whether the inclusion of such adjustments would be dilutive to EPS. See
Example 4-31 for more information.
4.7.3 Classification of Contract for Accounting Purposes
4.7.3.1 General
ASC 260-10
Contracts That May Be Settled in Stock or Cash
45-46 A contract that is reported as an asset or liability for accounting purposes may require an adjustment
to the numerator for any changes in income or loss that would result if the contract had been reported as an
equity instrument for accounting purposes during the period. That adjustment is similar to the adjustments
required for convertible debt in paragraph 260-10-45-40(b). . . .
Contracts That May Be Settled in Stock or Cash
55-32 Adjustments shall be made to the numerator
for contracts that are asset or liability classified, in accordance with
Section 815-40-25, but for which the potential common shares are included in
the denominator in accordance with the guidance in paragraph 260-10-45-45.
For purposes of computing diluted EPS, the adjustments to the numerator are
only permitted for instruments for which the effect on net income (the
numerator) is different depending on whether the instrument is accounted for
as an equity instrument or as an asset or liability (for example, those that
are within the scope of Subtopics 480-10 and 815-40).
55-33 The references in
paragraphs 260-10-45-30 and 260-10-45-45 for share-based payment
arrangements that are payable in common stock or in cash at the election of
either the entity or the grantee refer to using the guidance in paragraph
260-10-45-45A for purposes of determining whether shares issuable in
accordance with such plans are included in the denominator for purposes of
computing diluted EPS amounts. Accordingly, the numerator is not adjusted in
those circumstances. Paragraph 260-10-55-36A illustrates these
requirements.
The following table illustrates the guidance in paragraphs
260-10-45-45 through 45-46 and 260-10-55-32 through 55-34 for the effects of
contracts that may be settled in stock or cash on the computation of diluted
EPS.
Under ASC 260, in the calculation of diluted EPS, the accounting classification
of a contract must be consistent with its assumed settlement. Thus, when incremental
common shares reflecting the effect of share settlement of a contract that is classified
as an asset or liability are included in the denominator of diluted EPS, the numerator
must reflect accounting for the contract as an equity instrument. These requirements are
summarized in the table in ASC 260-10-55-36A. Note that when the numerator must be
adjusted, the adjustment should be made net of tax. In addition, the application of
numerator and denominator adjustments is subject to the antidilution requirements of ASC
260 (see Section
4.7.3.2).
Connecting the Dots
While footnote (a) in the table in ASC 260-10-55-36A only refers to settlement of a contract on a
gross (or physical) basis, the share settlement requirements referred to in that table also apply
to contracts that are net-share-settled.
ASC 260-10-55-36A applies to all equity-linked contracts and share-based payment
awards.20 Under ASC 815-40, an equity-linked freestanding financial instrument (or embedded
feature) can meet the conditions to be considered an equity instrument only if it is
both (1) indexed to the reporting entity’s stock and (2) meets certain additional
conditions for equity classification. The first requirement focuses on the indexation of
the contract, and the second requirement focuses on the form of settlement of the
contract.21 Although the requirements differ, under ASC 718, share-based payment awards must
also meet certain conditions regarding indexation and form of settlement to be
classified as equity instruments.22 Certain arrangements, whether within the scope of ASC 718 or ASC 815-40, may meet
the form-of-settlement requirements to be classified as equity instruments but do not
meet the indexation requirements and therefore must be classified as liabilities (or, in
the case of instruments within the scope of ASC 815-40, as assets in some
circumstances). When a contract is classified as an asset or liability for accounting
purposes because it does not meet the relevant indexation requirements in ASC 718 or ASC
815-40, but the effect of share settlement of the contract is included in the
denominator of diluted EPS, the calculation of diluted EPS must also include an
adjustment to the numerator to reflect the accounting as if the contract was classified
as an equity instrument even though such classification is prohibited by GAAP. See
Section 4.7.3.2 for further discussion of
antidilution considerations.
In applying ASC 260-10-55-36A to contracts for which a numerator adjustment may
be necessary, an entity should consider two
important matters:
-
Whether a numerator adjustment is necessary — The numerator can only be adjusted for a contract that is classified as an asset or liability (i.e., no adjustment would be made for a freestanding equity-classified contract). In addition, ASC 260-10-55-32 states, in part, that “the adjustments to the numerator are only permitted for instruments for which the effect on net income (the numerator) is different depending on whether the instrument is accounted for as an equity instrument or as an asset or liability.” For some contracts, the impact on net income during a reporting period would be the same regardless of the contract’s classification for accounting purposes. In these situations, the entity cannot adjust the numerator. For example, under ASC 718, an entity may recognize compensation cost for an award on the basis of the fair value of the award at the end of the reporting period, regardless of whether the award is classified as a liability or equity instrument, because the service inception date precedes the grant date. In this situation, it would be inappropriate to adjust the numerator.
-
The amount of the numerator adjustment — ASC 260-10-45-46 and ASC 260-10-55-32 indicate that the adjustment to the numerator should be limited to the difference in net income during the reporting period with respect to accounting for the contract as an asset or liability compared with accounting for the contract as an equity instrument. The accounting for some contracts affects net income regardless of how they are classified, but the amount reported in net income depends on a contract’s classification. For example, compensation cost is recognized on share-based payment awards regardless of whether they are classified as equity instruments or liability instruments, but the measurement differs depending on the classification. As another example, convertible debt securities affect reported net income regardless of whether the embedded conversion option is separated as a derivative liability or the fair value option is elected for the convertible debt security, but the amounts reported in net income differ depending on whether the embedded conversion option is separated or the fair value option is elected. In these types of situations, the numerator adjustment must be limited to the difference in reported net income of the assumed change in accounting classification. See Section 7.1.4 for further discussion of the application of this guidance to share-based payment awards.
Connecting the Dots
While ASC 260 only refers to reflecting a numerator adjustment for the difference in reported net income that results from the change in accounting classification, the numerator adjustment should also reflect the difference in income available to common stockholders for convertible preferred securities.
4.7.3.2 Antidilution and Control Number
As discussed in Section
4.1.2, an overriding principle underlying the calculation of diluted EPS is
“no antidilution” based on the control number. The application of the control number to
contracts subject to the guidance in ASC 260 on contracts that may be settled in cash or
stock is discussed below.
4.7.3.2.1 Contracts That Must Be Settled in Cash
No adjustments should be made to the numerator or the denominator in the
calculation of diluted EPS for equity-linked contracts or share-based payment
arrangements classified as assets or liabilities that must be settled in cash.
Therefore, the control number and antidilution concepts are not relevant in such
cases.
4.7.3.2.2 Contracts That Provide the Entity or Counterparty With the Choice of Settlement Method
The application of the control number and antidilution concepts to a
contract that permits the entity or the counterparty to choose the settlement method
depends on the facts and circumstances. Table 4-7 discusses when adjustments are made to
the numerator, and common shares are added to the denominator, in the calculation of
diluted EPS for the scenarios discussed in ASC 260-10-55-36A. In this table, it is
assumed that the contract is not a participating security for which the two-class
method of calculating diluted EPS may be required.
Table
4-7
Settlement for Diluted EPS
|
Accounting Classification
|
Control Number Is a Loss
|
Control Number Is Earnings
|
---|---|---|---|
Shares
|
Asset/liability
|
No adjustment is made to the numerator and no
incremental common shares are added to the denominator.(a)
|
Treasury Stock/Reverse Treasury
Stock Method
If the contract is an option or warrant and is
out-of-the-money, no adjustment is made to the numerator and no
incremental common shares are added to the denominator.(b) In
all other situations, the numerator is adjusted for any change in net
income during the period that would result if the contract had been
classified as an equity instrument and the incremental shares are added to
the denominator if the aggregate effect of these adjustments is dilutive
on the basis of the antidilution sequencing requirements of ASC 260.
If-Converted
Method(c)
In addition to the numerator (if any) and denominator
adjustments required under the if-converted method, as discussed in ASC
260-10-45-40, the numerator is adjusted for any change in net income
during the period that would result if the embedded conversion option had
not been separated as a derivative liability if the aggregate effect of
these adjustments is dilutive on the basis of the antidilution sequencing
requirements of ASC 260.
Contingently Issuable Share
Method
For common shares that are considered issuable for
diluted EPS on the basis of the guidance on contingently issuable shares
discussed in Section
4.5, the numerator is adjusted for any change in net income
during the period that would result if the contract had been classified as
an equity instrument and the contingently issuable shares are added to the
denominator if the aggregate effect of these adjustments is dilutive on
the basis of the antidilution sequencing requirements of ASC 260.
For potential common shares that are considered issuable
for diluted EPS on the basis of the guidance on contingently issuable
shares discussed in Section 4.5, the treasury stock method or reverse treasury
stock method should be applied, as described above.
|
Equity
|
No adjustment is made to the numerator and no
incremental common shares are added to the denominator.
|
Treasury Stock/Reverse Treasury
Stock Method
No adjustment is made to the numerator. Incremental
common shares are included under the treasury stock method or reverse
treasury stock method, if dilutive, on the basis of the antidilution
sequencing requirements of ASC 260.
If-Converted
Method(c)
The if-converted method is applied as described in ASC
260-10-45-40 if it is dilutive on the basis of the antidilution sequencing
requirements of ASC 260. No additional adjustment is made to the
numerator.
Contingently Issuable Share
Method
No adjustment is made to the numerator. The incremental
shares or potential common shares are included in the denominator on the
basis of the contingently issuable share method if this method is dilutive
in accordance with the antidilution sequencing requirements of ASC
260.
| |
Cash
|
Asset/liability
|
No adjustment is made to the numerator and no
incremental common shares are added to the denominator.
|
No adjustment is made to the numerator and no
incremental common shares are added to the denominator.
|
Notes to Table:
(a) An entity is not required to adjust the numerator
for an increase in the reported net loss that results from an accounting
classification of a contract that differs from its settlement for diluted
EPS purposes. This numerator adjustment is not required even if its effect
(after consideration of incremental shares that would be added to the
denominator) would result in a diluted loss per share that exceeds the
basic loss per share. This view is consistent with ASC 260-10-45-20, which
states, in part, that “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.”
(b) ASC 260-10-45-25 and ASC 260-10-45-35 require that
the treasury stock method or reverse treasury stock method be applied only
to options or warrants that are in-the-money. When an option or warrant is
out-of-the-money (which is determined on the basis of the average market
price during the reporting period as discussed in Sections 4.2.2.1 and
4.3.2.1), no adjustments must be made to the
numerator or denominator in the calculation of diluted EPS regardless of
the classification of the contract for accounting purposes or the
settlement for diluted EPS purposes.
(c) For convertible securities, the accounting
classification refers to the accounting for the embedded conversion
feature. It is assumed that the fair value option was not elected.
|
The examples in the next section illustrate the application of the
guidance in the tables above.
4.7.4 Examples
Example 4-30
Liability-Classified Call Option on Common Stock — Diluted
EPS Calculated on the Basis of Share Settlement
Company B enters into a freestanding written call option on its common stock
that must be physically settled by delivery of the full stated number of common
shares to the counterparty in exchange for payment of the exercise price.
Company B does not currently have enough authorized and unissued shares to
settle the contract in shares. As a result, under ASC 815-40, B must assume that
the contract may need to be cash-settled and must account for the written call
option as a liability at fair value, with changes in fair value recognized
through earnings. The written call option is not a participating security.
Although the call option is classified as a liability, in accordance with ASC 260-10-45-45 and 45-46, B should assume that the contract will be settled in shares for diluted EPS purposes. Therefore, the dilutive effect of the call option should be reflected by using the treasury stock method in accordance with ASC 260-10-45-22 and 45-23, and the mark-to-market adjustment recognized during the reporting period should be reversed from the numerator in accordance with ASC 260-10-55-32 and ASC 260-10-55-36A. Such adjustments should only affect B’s calculation of diluted EPS if they are dilutive on the basis of the antidilution sequencing requirements of ASC 260.
Example 4-31
Liability-Classified Call Option on Common Stock — Diluted
EPS Calculated on the Basis of Share Settlement
Assume the following regarding Company P during the first quarter ended March
31, 20X5:
-
P reports net income of $10 million.
-
P has 5 million weighted-average common shares outstanding during the quarter and reports basic EPS of $2.00 per share.
-
P has outstanding options that allow the counterparty to purchase 500,000 common shares at an exercise price of $40 per share. The options are not participating securities and are classified as a liability under ASC 815-40 because the counterparty can choose, upon exercise, to require settlement in cash or common shares.
-
P reports a $250,000 loss, net of tax, on the options in net income because the fair value of the options increases during the reporting period.
-
The average market price of P’s common stock during the period is $60 per share.
In calculating diluted EPS for the period, P must assume share settlement, if
dilutive. In accordance with the table in ASC 260-10-55-36A, the numerator
should be increased by $250,000 because, if the options had been classified as
an equity instrument, the $250,000 net loss on the options would not have
reduced reported net income. In addition, the denominator should be increased by
166,667 shares, which is calculated under the treasury stock method as 500,000 –
(500,000 × $40 ÷ $60 = 333,333). Diluted EPS is calculated as follows:
Since share settlement is dilutive, P should report diluted EPS of $1.98.
Note that because an assumption of cash settlement results in no adjustments to
the numerator or denominator, an entity only needs to consider whether share
settlement is dilutive to EPS on the basis of the antidilution sequencing
requirements in ASC 260. If share settlement is not dilutive, no adjustments
would be made to the numerator or denominator. That is, the dilution is based on
an approach consistent with cash settlement because share settlement is
antidilutive.
Footnotes
19
This EPS accounting applies even if a contract is classified as a
liability for accounting purposes because the issuing entity does not control the
ability to issue the maximum number of shares that it could be required to deliver
when the contract is share-settled.
20
See Section
7.1.4 for further discussion of share-based payment awards.
21
See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for
further discussion of these requirements.
22
See Chapter
5 of Deloitte’s Roadmap Share-Based Payment Awards for further
discussion of these requirements.
4.8 Diluted EPS for Specific Types of Transactions or Events
4.8.1 Prior-Period Adjustments
An entity may be required to restate its previously reported net income as a result of a correction of an error. An entity may also be required to retrospectively adjust previously reported net income for other reasons (e.g., a change in accounting principle that is applied retrospectively). As discussed in Section 8.1, in these situations, previously reported 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).
4.8.2 Shareholder Distributions
4.8.2.1 Stock Dividends and Stock Splits
In a stock dividend, stock split, or reverse stock split, basic and diluted EPS must be retrospectively
adjusted for all prior financial reporting periods. See further discussion in Section 8.2.1.
4.8.2.2 Rights Issue
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. A rights issue may contain a bonus element
that is akin to a stock dividend, in which case retrospective adjustment to basic and diluted EPS is
required for all prior reporting periods. See further discussion in Section 8.2.2.
4.8.3 Certain Issuances of Common Stock
4.8.3.1 Common Stock Subscriptions
Stock subscriptions are a mechanism by which an entity can 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. See Section 8.3.1 for
discussion, including illustrative examples, of the impact on basic and diluted EPS of stock subscription
agreements that must be settled in common stock.
4.8.3.2 Common Stock Issued for Note Receivable
The facts and circumstances associated with legally outstanding common stock that was issued in return
for a note receivable will vary depending on the contractual terms of the arrangement. ASC 260 does
not provide specific guidance on situations in which an entity has issued shares of common stock to
an investor that are legally outstanding and not subject to any vesting conditions in return for a note
receivable. The determination of whether the common shares issued in return for a note receivable
should be considered outstanding and included in the denominator in the calculation of basic EPS, or
should be treated as potential common shares and included only in diluted EPS under the treasury
stock method, depends on whether the entity has the ability and intent to cancel the shares if the note
receivable is not repaid. See further discussion in Section 8.3.2.
4.8.3.3 Distributions That Are Considered Issuances of Common Stock
Certain entities, particularly real estate investment trusts and other entities
that are required to periodically distribute a certain portion of their taxable income,
make distributions to common shareholders that give the individual 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. As discussed in Section 8.3.3, the common stock portion of these
types of distributions is accounted for as a share issuance rather than as a stock
dividend. While the common stock portion of these dividends will not be reflected in the
calculation of basic EPS until the shares are issued, diluted EPS will be affected
before the common shares issued for the distribution become outstanding. The impact on
diluted EPS must be accounted for in accordance with the guidance in ASC 260-10-45-45
and 45-46 on contracts that may be settled in cash or stock at the option of the
counterparty. Under this guidance, the entity must presume that the holders of the
entity’s common stock will elect to receive shares. The receipt of shares will always be
more dilutive than the receipt of cash because the measurement of the liability for the
dividend payable is the same regardless of the settlement method (i.e., the monetary
value of the dividends is the same and, therefore, the entity is not required to
remeasure the dividend liability). See further discussion in Section 8.3.3.
4.8.3.4 Nominal Issuances
A nominal issuance of common stock involves a transaction in which the total consideration payable by the party that receives the shares is nominal in relation to the fair value of the common shares issued. A nominal issuance may also be associated with an issuance of potential common stock, such as an option or warrant to purchase common stock. Under ASC 260, nominal issuances of common stock must be treated retrospectively in the same manner as a stock dividend or stock split. See further discussion in Section 8.3.4.
4.8.3.5 Own-Share Lending
An entity may loan its shares of common stock to an investment bank or investor in conjunction with an issuance of convertible debt. Such shares are “loaned” because the counterparty is unable to borrow shares in the market to hedge its exposure to the conversion option in the convertible debt or because the borrowing cost is prohibitive. As noted in ASC 470-20-45-2A, although loaned shares are legally outstanding, they are generally not considered outstanding common shares in the calculation of diluted EPS. See further discussion in Section 8.5.
4.8.3.6 Unit Structures
Unit structures represent a combination of (1) a debt instrument or a preferred security and (2) a variable-share forward contract to issue common shares or an option to issue common shares to the counterparty. An entity must evaluate the terms of these types of issuances to determine whether one or more of the component instruments is a participating security and whether the if-converted or treasury stock method must be applied to calculate diluted EPS.
ASC 260-10-55-9 specifies that when options or warrants (as well as forward sale contracts) require or permit the counterparty to elect to tender debt or other securities of the issuer (or its parent or subsidiary), the if-converted method applies unless tendering cash would be more advantageous to the counterparty. Therefore, when the unit structure permits the counterparty to tender either the debt instrument or preferred security as payment of the forward or exercise price, the if-converted method is applied unless it is more advantageous to the counterparty to pay cash to acquire common shares.
The terms of certain unit structures must be further considered because the counterparty does not have the unconditional right to tender the debt instrument or preferred security to the entity in satisfaction of the forward price or exercise price payable to acquire the common shares. For example, a unit structure may consist of the following instruments and terms:
- An entity issues a note with a term of five years and a forward sale contract that requires the counterparty to purchase the entity’s common stock at the end of three years (i.e., share settlement is required). The principal amount of the note is the same as the forward price in the forward sale contract.
- Three months before the settlement of the forward contract, the note is subject to remarketing at an interest rate that results in net sales proceeds at least equal to the note’s principal amount.
- If the remarketing is successful, the counterparty can elect to (1) retain the note with a remaining term of two years and three months (generally with a remarketed interest rate) or (2) sell the note in the remarketing for cash proceeds that equal or exceed the forward price in the forward sale contract. The counterparty cannot elect to tender the note to the issuer in satisfaction of the forward price in the forward sale contract.
- If the remarketing is unsuccessful, the counterparty may elect to put the note to the entity in satisfaction of the forward price on the forward sale contract or pay the forward price in cash.
For these types of arrangements, the probability of a successful remarketing must be assessed. If it is
probable that the remarketing will be successful, the entity may apply the treasury stock method to the
forward sale contract. If, at any point, it is not probable (or no longer probable) that the remarketing
will be successful, the entity must apply the if-converted method because it is not advantageous for
the counterparty to pay cash in lieu of tendering the note to satisfy the forward price in the forward
sale contract. Prior reported EPS amounts should not be adjusted upon a change in probability of a
successful remarketing.
An entity should carefully consider individual facts and circumstances, and
specific contractual terms, of any financing
transaction in evaluating the appropriate
accounting and related EPS treatment. In the above
example, if the counterparty could elect to tender
the note to the issuer in satisfaction of the
forward price in the forward sale contract even if
the remarketing is successful, the entity would
need to consider the most advantageous settlement
from the perspective of the counterparty to
determine whether the if-converted method or
treasury stock method should be applied in the
calculation of diluted EPS. If neither cash nor
tendering the debt would be considered
advantageous, the if-converted method should be
applied in the calculation of diluted EPS.
The terms of certain unit structures involving
preferred stock significantly differ from those
involving debt instruments. Accordingly, it may
not be appropriate to apply the treasury stock
method to the equity purchase contract in a unit
structure that involves preferred stock. An entity
must evaluate the form and substance of these
transactions to appropriately calculate diluted
EPS.
4.8.4 Certain Repurchases of Common Stock
4.8.4.1 Forward to Repurchase Common Stock and Mandatorily Redeemable Common Stock
ASC 480-10
EPS
45-4 Entities that have
issued mandatorily redeemable shares of common stock
or entered into forward contracts that require
physical settlement by repurchase of a fixed number
of the issuer’s equity shares of common stock in
exchange for cash shall exclude the common shares
that are to be redeemed or repurchased in
calculating basic and diluted earnings per share
(EPS). Any amounts, including contractual
(accumulated) dividends and participation rights in
undistributed earnings, attributable to shares that
are to be redeemed or repurchased that have not been
recognized as interest costs in accordance with
paragraph 480-10-35-3 shall be deducted in computing
income available to common shareholders (the
numerator of the EPS calculation), consistently with
the two-class method set forth in paragraphs
260-10-45-60 through 45-70.
4.8.4.1.1 Forward Purchase Contracts Within the Scope of ASC 480-10-45-4
Under ASC 260-10-45-35, an entity is generally required to apply the reverse treasury stock method
to calculate the dilutive effect on forward purchase contracts related to the entity’s common stock.
However, ASC 480-10-45-4 is an exception to this guidance that applies only to forward contracts that
must be physically settled by repurchase of a fixed number of the entity’s common shares in exchange
for cash. For these contracts, the shares of common stock to be repurchased are excluded from both
basic and diluted EPS and the reverse treasury stock method is not applied in the calculation of diluted
EPS. All other forward purchase contracts that are not subject to the exception in ASC 480-10-45-4 must
be reflected in dilutive EPS under ASC 260-10-45-35 if they are dilutive. Thus, the reverse treasury stock method would apply to the following types of forward contracts that obligate the issuer to purchase common shares:
- Forward contracts to purchase outstanding shares that give the counterparty (holder) the option to elect either gross physical or net settlement.
- Forward contracts to purchase a variable number of outstanding shares that may be settled on either a gross physical or net basis.
4.8.4.1.2 Mandatorily Redeemable Common Stock Within the Scope of ASC 480-10-45-4
In accordance with ASC 480-10-45-4, the denominator in the calculations of basic and diluted EPS should not include any mandatorily redeemable common shares that must be physically settled by repurchase of a fixed number of the issuer’s equity shares in exchange for cash.
4.8.4.2 Accelerated Share Repurchase Programs
An accelerated share repurchase program involves a combination of transactions that includes (1) an immediate repurchase of common shares and (2) a forward contract to either issue common shares or receive additional common shares depending on the volume-weighted average daily purchase prices of the entity’s common stock purchased in the market by the counterparty. The entity can generally choose to settle the forward contract in cash or shares of common stock; however, in some cases, it must receive cash when it is in a gain position. For diluted EPS purposes, the entity must generally apply the treasury stock method to determine the dilutive effect of the forward contract. See Section 8.4.2 for further discussion of the application of the treasury stock method to the forward contract.
4.8.4.3 Redeemable Equity Securities
An entity may have outstanding equity securities (which include NCIs) that are
classified in temporary equity in accordance with ASC 480-10-S99-3A. Redeemable equity
securities are discussed in detail in Chapter 3 and Section
8.8.4. While remeasurement adjustments required under ASC 480-10-S99-3A may
affect income available to common stockholders in the calculation of basic EPS, there is
generally no incremental impact on the denominator of diluted EPS because the settlement
of any redemption is in cash rather than the issuance of common shares. However, if the
redeemable equity securities are convertible, the if-converted method must be applied in
the calculation of diluted EPS.
4.8.4.4 Reclassification of Common Stock to a Liability
As discussed in Section 3.2.4.4, a conditionally redeemable common stock instrument may become mandatorily redeemable as a result of the resolution of a condition associated with redemption. In these circumstances, the common shares are removed from the denominator in the calculation of basic EPS as of the reclassification date. There is generally no incremental impact on diluted EPS from such reclassification because removing the common shares as of an earlier date would be antidilutive. If the common stock subject to reclassification is convertible or exchangeable, provided that the event giving rise to the reclassification from an equity instrument to a liability does not affect the conversion or exchange feature, the common stock would continue to be subject to the if-converted method of calculating diluted EPS if this method is more dilutive than the two-class method of calculating diluted EPS. In fact, the common stock may be subject to the if-converted method for periods both before and after reclassification.
4.8.4.5 Tracking Stock
Some entities have issued classes of stock characterized as “tracking” or
“targeted” stock, which measure the performance of
a specific business unit, activity, or asset of
the entity. Shares of tracking stock are traded as
separate securities although they typically do not
have any specific claim on the related assets and
may have limited or no voting rights. According to
ASC 260-10-45-60B, an entity with tracking stock
must calculate and present EPS for each class of
common stock by using the two-class method.
The terms of tracking stock often allow the issuing entity, at its option, to
exchange or redeem shares of tracking stock for shares of the issuer’s main common stock
in such a way that the entity would have one less class of common stock outstanding. The
terms of this feature generally require an entity to pay a premium to the class being
redeemed as a result of the transaction. When the entity pays a premium over fair value
to redeem a class of tracking stock, the premium should be treated as a reduction from
net income in arriving at income available to common stockholders of the class whose
shares are being used for the redemption. The rationale for this treatment is that the
holders of the tracking stock being redeemed have received a benefit that constitutes an
additional contractual return to them. That benefit is absorbed by the class of common
stock for which the entity has issued shares in return for the extinguishment of the
class of tracking stock.
For diluted EPS, the if-converted method should be applied when a class of
tracking stock that can be exchanged or converted into the issuer’s main common stock is
outstanding during a reporting period, including during a period in which the tracking
stock is exchanged or converted. The if-converted method applies only to the calculation
of diluted EPS for the class of stock into which the tracking stock is convertible and
should be applied only if it is more dilutive than the two-class method of calculating
diluted EPS for this class. While an entity may be required to apply the if-converted
method to the class of stock into which the tracking stock is convertible, it would not
be required to include, as an adjustment to the numerator, the premium payable on
exchange or conversion in each reporting period. See further discussion in Section 4.4.2.2.4.
4.8.5 Business Combinations and Reorganizations
ASC 260-10-55-17 does not permit the retrospective adjustment of EPS for shares
of common stock issued in a business combination.
Rather, such shares issued as part of the purchase
price affect the weighted-average common shares
outstanding in the calculation of diluted EPS only
from the issuance date. However, in reverse merger
transactions and certain reorganizations that are
considered akin to split-like situations,
the number of shares of common stock included in
the denominator of diluted EPS is retrospectively
adjusted to the earliest period presented to
reflect the recapitalization. See Section
8.6 for discussion of these types of
situations as well as of the impact of spin-off
transactions.
4.8.6 Master Limited Partnerships
MLPs generally have multiple classes of outstanding partnership interests and
therefore must apply the two-class method to calculate basic and diluted EPS. If an MLP
has outstanding partnership interests that may be converted into another class of
partnership interest, diluted EPS should be calculated on the basis of the more dilutive
of the two-class method or the if-converted method. If an MLP has issued forwards,
options, warrants, or similar instruments to sell partnership interests, diluted EPS
should be calculated on the basis of the two-class method or the treasury stock method as
applicable. See Section 8.9
for further discussion of the EPS accounting considerations related to MLPs.
4.8.7 Common Stock Issued in R&D Arrangements
See Section 8.10
for discussion of the impact that the sponsor for a specific transaction
involving a R&D entity has on net income and income available to common
stockholders.
4.8.8 Other Compensatory Arrangements
Section 7.2
discusses when common stock held by an ESOP is
considered outstanding and the accounting for
diluted EPS by sponsors of ESOPs. Section
7.3 discusses the impact on the
calculation of diluted EPS in other compensatory
arrangements, including profits interests and
common stock owned by a rabbi trust.
4.9 Year-to-Date Calculations of Diluted EPS
4.9.1 Treasury Stock Method
ASC 260-10
Applying the Treasury Stock
Method
Year-to-Date Computations
55-3 The number of incremental
shares included in quarterly diluted EPS shall be
computed using the average market prices during the
three months included in the reporting period. For
year-to-date diluted EPS, the number of incremental
shares to be included in the denominator shall be
determined by computing a year-to-date weighted average
of the number of incremental shares included in each
quarterly diluted EPS computation. Example 1 (see
paragraph 260-10-55-38) provides an illustration of that
provision.
55-3A Computation of
year-to-date diluted EPS when an entity has a
year-to-date loss from continuing operations including
one or more quarters with income from continuing
operations and when in-the-money options or warrants
were not included in one or more quarterly diluted EPS
computations because there was a loss from continuing
operations in those quarters is as follows. In computing
year-to-date diluted EPS, year-to-date income (or loss)
from continuing operations shall be the basis for
determining whether or not dilutive potential common
shares not included in one or more quarterly
computations of diluted EPS shall be included in the
year-to-date computation.
55-3B Therefore:
- When there is a year-to-date loss, potential common shares should never be included in the computation of diluted EPS, because to do so would be antidilutive.
- When there is year-to-date income, if in-the-money options or warrants were excluded from one or more quarterly diluted EPS computations because the effect was antidilutive (there was a loss from continuing operations in those periods), then those options or warrants should be included in the diluted EPS denominator (on a weighted-average basis) in the year-to-date computation as long as the effect is not antidilutive. Similarly, contingent shares that were excluded from a quarterly computation solely because there was a loss from continuing operations should be included in the year-to-date computation unless the effect is antidilutive.
Example 12 (see paragraph 260-10-55-85) illustrates this guidance.
As discussed in ASC 260-10-55-3 through 55-3B, the control number for
calculating year-to-date diluted EPS and applying the antidilution sequencing
requirements of ASC 260 is year-to-date net income.23 The number of incremental common shares included in the denominator under
the treasury stock method, when dilutive, must be based on a year-to-date
average of the number of incremental common shares calculated during each
quarterly financial reporting period. While incremental common shares may not
have been included in diluted EPS during a quarterly financial reporting period
because the control number for the period was a loss, to calculate year-to-date
diluted EPS in accordance with ASC 260-10-55-3 through 55-3B, an entity is
nevertheless required to calculate the number of incremental common shares under
the treasury stock method that would have been included in each quarterly
calculation of diluted EPS if the effect had been dilutive. In doing so, as
discussed in Section
4.2.2.1, the entity does not include out-of-the-money options and
warrants in quarterly diluted EPS. Thus, if options or warrants are
out-of-the-money in a quarterly financial reporting period, zero incremental
common shares will be included for that quarter in the year-to-date average.
However, for options or warrants that were in-the-money in a quarterly financial
reporting period but not included in diluted EPS because doing so would have
been antidilutive on the basis of the antidilution sequencing requirements of
ASC 260, such options or warrants may need to be included in year-to-date
diluted EPS since the antidilution sequencing requirements in a year-to-date
calculation of diluted EPS must be based on the year-to-date reported net
income.
Connecting the Dots
It may be intuitive to think that the incremental common shares included in year-to-date diluted
EPS should be calculated as if the year-to-date period was a discrete period. However, that
approach is not allowed for contracts subject to the treasury stock method. Using a year-to-date
approach to calculate the incremental common shares included in year-to-date diluted EPS may
be materially inconsistent with the requirements of ASC 260-10-55-3 through 55-3B. Consider
the following two examples:
- An entity calculating diluted EPS for an annual period that reports net income has 10 million options to sell common shares at $25 per share. The options are classified as equity instruments and must be share-settled. The average market prices of the entity’s common stock for the quarterly reporting periods in the annual period are $24.00, $24.50, $25.00, and $40.00 per share. The average market price of the entity’s common stock for the year is $28.38 per share. Under the approach required in ASC 260-10-55-3 through 55-3B, the incremental common shares added to the denominator would be 937,500, representing the average of the incremental shares for the fourth quarter and zero incremental shares for the first three quarters because the options are not in-the-money. However, when the year-to-date average market price is used, the incremental shares added to the denominator would be 1,190,980.
- An entity calculating diluted EPS for an annual period with reported net income has 10 million options to sell common shares at $25 per share. The options are classified as equity instruments and must be share-settled. The average market prices of the entity’s common stock for the quarterly reporting periods in the annual period are $26.00, $26.50, $27.00, and $20.00 per share. The average market price of the entity’s common stock for the year is $24.88 per share. Under the approach required in ASC 260-10-55-3 through 55-3B, the incremental common shares added to the denominator would be 422,849, representing the average of the incremental shares for each of the first three quarters and zero incremental shares for the fourth quarter because the options are not in-the-money. However, when the year-to-date average market price is used, the incremental shares added to the denominator would be zero because the options are not in-the-money.
If an instrument subject to the treasury stock method is a participating security, the more dilutive of the
treasury stock method or the two-class method of calculating diluted EPS must be applied, as discussed
in Section 5.5.4. See Section 4.9.5 for information about situations in which the settlement method
assumed for diluted EPS purposes differs from the accounting classification of a contract subject to the
treasury stock method.
4.9.1.1 Example
ASC 260-10
Example 12: Computing Year-to-Date Weighted-Average Shares Outstanding
55-85 The following Cases illustrate the guidance in paragraphs 260-10-55-3A through 55-3B for the quarterly
and annual computations of basic and diluted EPS for a company with options outstanding (equal to 20,000
incremental shares) that were in the money for the entire year (for simplicity purposes, this Example assumes
that the stock price never changed). Case A addresses year-to-date loss, and Case B addresses year-to-date
income. Note that in Case A, due to a loss for the period, zero incremental shares are included because the
effect would be antidilutive. Note that in Case B, zero shares included due to loss in the period.
Case A: Year-to-Date Loss
55-86 The following tables illustrate the computation of quarterly and year-to-date EPS.
Case B: Year-to-Date Income
55-87 The following tables illustrate the computation of quarterly and year-to-date EPS.
Note that if the options had been out of the money in any quarter, zero incremental shares would have been
included for that quarter in the year-to-date averaging.
4.9.2 Reverse Treasury Stock Method
The same year-to-date approach required for the treasury stock method would
apply under the reverse treasury stock method. However, because written put
options and forward purchase contracts are classified as liabilities (or assets
in some circumstances) and generally recognized at fair value, with changes in
fair value recognized in earnings (see Section 4.3.2.1), when the reverse
treasury stock method is applied for diluted EPS purposes, these instruments are
also subject to the year-to-date guidance on diluted EPS related to contracts
that have an assumed settlement method for diluted EPS that differs from the
classification for accounting purposes. See further discussion in Section 4.9.5.
4.9.3 If-Converted Method
As with the guidance applicable to the treasury stock method, the control number
for year-to-date diluted EPS is net income for the year-to-date period and the
antidilution sequencing requirements are applied on the basis of year-to-date
net income. The guidance on the weighting of incremental shares provided for
contracts subject to the treasury stock method is generally not relevant for
convertible securities subject to the if-converted method. See Example 4-32 and
Connecting the Dots below for more
information.
Connecting the Dots
If the control number for the year-to-date period is a loss, the if-converted method should
not be applied because its effect would be antidilutive. If the control number for the year-to-date
period is income, an entity should apply the if-converted method, assuming conversion
at the beginning of the period or the date of issuance of the convertible security, if later, if the
application of this method is dilutive to the year-to-date calculation of diluted EPS on the basis of
the antidilution sequencing requirements of ASC 260 as they apply on a year-to-date basis. This
is the case even if the if-converted method was not applied in one or more quarterly financial
reporting periods because there was a net loss during the period or the convertible security was
antidilutive for the period on the basis of the antidilution sequencing requirements in ASC 260.
Questions arise regarding how to calculate diluted EPS under the if-converted
method for convertible securities that are contingently convertible on the basis
of (1) only a substantive non-market-based contingency or (2) a market price
trigger and some other substantive non-market-based
contingency. As discussed in Section 4.4.3, for each quarterly financial reporting period,
the if-converted method should be applied only if the non-market-based
contingency has been met as of the end of the reporting period. If the
non-market-based contingency is met as of the reporting date and application of
the if-converted method is dilutive, the effect should be included in diluted
EPS from the beginning of the quarterly reporting period or the date of
issuance, if later. This is consistent with the approach to diluted EPS for
contingently issuable shares. While ASC 260 does not specifically address how to
calculate year-to-date EPS under the if-converted method when the
non-market-based contingency is met for only some of the quarterly periods
within a year-to-date period, the approach applied to contingently issuable
shares should be used to calculate diluted EPS on a year-to-date basis. Thus, if
the control number is income and the effect of conversion is dilutive on the
basis of the antidilution sequencing requirements of ASC 260, the common shares
included in the denominator would be weighted for the interim periods that were
included in the calculation of diluted EPS. The numerator adjustments under ASC
260-10-45-40 would be made only for the interim periods for which the common
shares issuable upon conversion were included. See Example 4-33 for more information.
If a convertible security subject to the if-converted method is a participating
security, the more dilutive of the if-converted method or the two-class method
of calculating diluted EPS must be applied, as discussed in Section 5.5.4. See
Section 4.9.5
for further discussion of situations in which the settlement method assumed for
diluted EPS purposes differs from the accounting classification of the
convertible security subject to the if-converted method.
Connecting the Dots
Under ASC 260-10-45-40, an entity must perform a
treasury-stock-type calculation for convertible debt instruments subject
to the if-converted method that require the issuer to pay the principal
amount in cash upon conversion (i.e., an Instrument C convertible debt
instrument). In particular, an entity would determine the effect on
diluted EPS by calculating the number of common shares that would be
issuable to settle the excess conversion value. The entity would perform
this calculation on the basis of its average stock price during the
period.
ASC 260-10-55-84 through 55-84B appear to indicate that
for calculations of year-to-date diluted EPS, an entity should use its
average share price for the year. However, this approach would be
inconsistent with the statement in the example that “[t]he conversion
premium should be included in diluted earnings per share based on the
provisions of paragraphs 260-10-45-45 through 45-46 and 260-10-55-32
through 55-36A.” These paragraphs require an entity to apply ASC
260-10-55-3, which states that in the calculation of year-to-date
diluted EPS, “the number of incremental shares to be included in the
denominator shall be determined by computing a year-to-date weighted
average of the number of incremental shares included in each quarterly
diluted EPS computation.” Therefore, although ASC 260-10-55-84 through
55-84B appear to indicate that the average share price for the year
should be used in the calculation of diluted EPS, an entity should
determine year-to-date diluted EPS for a convertible debt instrument
that requires the issuer to pay the principal amount in cash by
calculating a year-to-date average of the number of incremental shares
included in each calculation of quarterly diluted EPS. Such an approach
is consistent with the treasury stock method.
4.9.3.1 Examples
Example 4-32
Application of If-Converted Method to Quarterly and Annual Diluted EPS When There Are Periods of
Income and Loss
Company G reports the amounts below during its quarterly financial reporting periods for the year ended
December 31, 20X9; G does not report a discontinued operation during the year ended December 31, 20X9.
Assume that G has $5 million of 7.5 percent nonparticipating noncontingently convertible debt securities
outstanding for the entire year. The conversion price of the convertible securities is $25.00; therefore, the
debt securities are convertible into 200,000 common shares. The convertible securities must be settled in G’s
common shares and are accounted for at amortized cost. Company G has a tax rate of 25 percent.
Diluted EPS for each quarter in the year ended December 31, 20X9, would be calculated as follows:
Diluted EPS for the year ended December 31, 20X9, would be calculated as follows:
Note that because G reports a net loss during the third quarter, the annual diluted EPS amount of $1.83 does
not equal the sum of the quarterly diluted EPS amounts reported of $1.44 ($0.81 + $0.46 + $(1.00) + $1.17 =
$1.44). Further, if G had reported a net loss of $2,000,000 or $4.00 loss per basic share for the third quarter,
it would have reported a net loss of $500,000 for the year. Therefore, while the amounts of diluted EPS for the
first, second, and fourth quarters above would be unchanged, the diluted EPS for the year ended December 31,
20X9, would have been a $1.00 loss per share, which would have been the same amount reported as basic loss
per share.
Example 4-33
Application of If-Converted Method to Quarterly and Annual Diluted EPS for Contingently
Convertible Debt
Company H reported the amounts below during its quarterly financial reporting periods for the year ended
December 31, 20X4; H did not report a discontinued operation during the year ended December 31, 20X4.
Assume that H has $5 million of 7.5 percent nonparticipating contingently
convertible debt securities outstanding for the
entire year. The conversion price of the convertible
securities is $25.00; therefore, the debt securities
are convertible into 200,000 common shares. The
convertible securities must be settled in G’s common
shares and are accounted for at amortized cost. The
convertible securities are only convertible if the
following two conditions are met:
-
The market price of H’s common stock is $41.00 or more.
-
The occupancy rate of H’s commercial rental properties is 90 percent or more.
Company G has a tax rate of 25 percent.
Assume the following conditions at the end of each quarter in the year ended December 31, 20X4:
In accordance with ASC 260-10-45-44, an entity should include the convertible securities in diluted EPS,
assuming dilution, only in periods in which the non-market-based contingency is met. Therefore, the
if-converted method applies for the first, second, and fourth quarters of 20X4. The fact that the market price
trigger is not met in the second quarter does not preclude the application of the if-converted method for the
second quarter since market price triggers are disregarded in the determination of whether the if-converted
method applies to contingently convertible debt instruments.
Diluted EPS for each quarter in the year ended December 31, 20X4, would be calculated as follows:
Diluted EPS for the year ended December 31, 20X4, would be calculated as follows:
4.9.4 Contingently Issuable Share Method
ASC 260-10
Contingently Issuable Shares
45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is,
contingent shares shall be weighted for the interim periods in which they were included in the computation of
diluted EPS.
The approach to year-to-date diluted EPS that is applied to contingently
issuable shares or contingently issuable potential common shares is consistent
with that applied to potential common shares subject to the treasury stock
method. The incremental shares included in the denominator in the calculation of
diluted EPS, if they are dilutive to the calculation of year-to-date diluted EPS
on the basis of the antidilution sequencing requirements of ASC 260, are based
on a weighted average of the common shares included in each quarterly
calculation of diluted EPS. If the control number for the year-to-date period is
a loss, no incremental common shares are included in the denominator for the
year-to-date period even if incremental common shares were included in one or
more quarterly financial reporting periods because of net income for those
quarterly periods. Similarly, if the control number for the year-to-date period
is income, incremental common shares that were excluded from the denominator for
quarterly periods because of quarterly losses are included in the calculation of
year-to-date diluted EPS if the approach is dilutive on the basis of the
antidilution sequencing requirements in ASC 260. As noted in Section 4.9.1, the
antidilution sequencing requirements are applied to a calculation of
year-to-date diluted EPS on the basis of year-to-date net income.
If a contingently issuable share arrangement is a participating security, the more dilutive of the
contingently issuable share method or the two-class method of calculating diluted EPS must be applied,
as discussed in Section 5.5.4. If the settlement method assumed for diluted EPS purposes differs from
the accounting classification of a contract subject to the treasury stock method, see Section 4.9.5.
4.9.4.1 Examples
ASC 260-10-55-53 through 55-56 provide an example illustrating the calculation of quarterly and year-to-date
diluted EPS for an entity that has contingently issuable common shares based on net income and a
nonfinancial performance measure. The example highlights the following requirements of ASC 260:
- The number of common shares included in the denominator of quarterly diluted EPS is equal to the number of common shares that would be issued if the end of the reporting period was the end of the contingency period.
- Common shares may be included in one quarterly reporting period but not in subsequent quarterly reporting periods; as a result, there may be volatility in the amounts of quarterly diluted EPS.
- The calculation of year-to-date diluted EPS is based on the weighted-average common shares that have been assumed to be issuable in each quarterly financial reporting period.
ASC 260-10
Example 3: Contingently Issuable Shares
55-53 This Example
illustrates the contingent share provisions
described in paragraphs 260-10-45-13 and
260-10-45-48 through 45-57. This Example has the
following assumptions:
-
Entity A had 100,000 shares of common stock outstanding during the entire year ended December 31, 20X1. It had no options, warrants, or convertible securities outstanding during the period.
-
Terms of a contingent stock agreement related to a recent business combination provided the following to certain shareholders of Entity A:
-
1,000 additional common shares for each new retail site opened during 20X1
-
5 additional common shares for each $100 of consolidated, after-tax net income in excess of $500,000 for the year ended December 31, 20X1.
-
-
Entity A opened two new retail sites during the year:
-
One on May 1, 20X1
-
One on September 1, 20X1.
-
-
Entity A’s consolidated, year-to-date after-tax net income was:
-
$400,000 as of March 31, 20X1
-
$600,000 as of June 30, 20X1
-
$450,000 as of September 30, 20X1
-
$700,000 as of December 31, 20X1.
-
55-54 Note that in computing
diluted EPS for an interim period, contingent shares
are included as of the beginning of the period. For
year-to-date computations, paragraph 260-10-45-49
requires that contingent shares be included on a
weighted-average basis.
55-55 The following table illustrates the quarterly and annual calculation of basic and diluted EPS.
Example 4-34
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings (Single
Earnings Target)
For the scenario discussed in Example 4-15, incremental common shares should be included in year-to-date
diluted EPS on a weighted-average basis. If it is assumed that X had 200,000 weighted-average common
shares outstanding and no other potential common shares and that the contingently issuable shares were not
classified as an asset or liability for accounting purposes, the calculation of X’s basic and diluted EPS for the
annual period would be as follows:
The weighted-average number of shares added for diluted EPS is calculated as follows:
4.9.5 Contracts That May Be Settled in Cash or Stock
ASC 260-10
Contracts That
May Be Settled in Stock or Cash
55-34 Year-to-date diluted
EPS calculations may require an adjustment to the
numerator in certain circumstances. For example, for
contracts that are share settled for EPS purposes, the
numerator adjustment is equal to the earnings effect of
the change in the fair value of the asset or liability
recorded pursuant to Section 815-40-35 during the
year-to-date period. In that example, the number of
incremental shares included in the denominator should be
determined in accordance with the guidance in paragraph
260-10-55-3.
As discussed in Section 4.7.3, a numerator adjustment is
required when a contract is classified (in whole or in part) as an asset or
liability for accounting purposes but the potential common shares are included
in the denominator of the calculation of diluted EPS. ASC 260-10-55-34 requires
that, in such situations, the numerator adjustment be calculated on the basis of
the income statement for the year-to-date period. However, the number of shares
included in the denominator must be calculated in accordance with ASC
260-10-55-3 (e.g., under the treasury stock, reverse treasury stock, and
contingently issuable share methods, the incremental common shares are included
on a year-to-date basis by using an average of the incremental common shares
calculated on a discrete quarterly basis). In other words, a year-to-date
approach is used to determine the numerator adjustment and an averaging approach
is used to determine the denominator adjustment, if these adjustments are
dilutive on the basis of the antidilution sequencing requirements of ASC 260.
See Section 4.9.3
for further discussion of the accounting for year-to-date diluted EPS under the
if-converted method.
Connecting the Dots
It is possible that an entity would reverse the entire mark-to-market
adjustment for the year-to-date period on a contract classified as an
asset or liability but only include incremental shares for one quarterly
period in a year-to-date calculation of diluted EPS (e.g., a
liability-classified option was in-the-money for only one quarterly
period). This result arises from the year-to-date approach used for the
numerator adjustment and the averaging approach used for the denominator
adjustment. However, an entity would never make the numerator adjustment
if no incremental shares were added to the denominator for the
year-to-date period. Similarly, neither the numerator nor the
denominator adjustment would be made if the combined result of those
adjustments was antidilutive for the year-to-date period.
4.9.6 Entities That Do Not Present Interim EPS
Some entities that are not subject to the periodic reporting requirements of the Exchange Act only
present EPS amounts in annual financial statements. In these situations, an entity is not required to
calculate EPS on a quarterly basis so that it can compute EPS amounts on an annual basis. Rather,
the annual period may be treated as a discrete period in the same manner in which a quarterly
financial reporting period is considered a discrete period for SEC registrants that file quarterly financial
statements on Form 10-Q. Treating an annual period as a discrete period could result in significantly
different diluted EPS amounts calculated under the treasury stock, reverse treasury stock, and
contingently issuable share methods.
SEC Considerations
The above guidance is not intended to apply to entities
that present diluted EPS in registration statements filed with the SEC.
Such entities must apply the guidance in ASC 260 on year-to-date diluted
EPS to any amounts of diluted EPS that are presented or disclosed.
Footnotes
23
For simplicity, in Section 4.9, we refer to “net
income” as the control number. However, as discussed in Section 4.1.2.2,
for an entity that has dividends on preferred stock, the control number
is income available to common stockholders. For an entity with a
discontinued operation, the control number is income available to common
stockholders from continuing operations. For an entity with an NCI, the
control number is income attributable to common stockholders of the
parent. See further discussion in Table 4-2.
4.10 Comprehensive Example
ASC 260-10-55-38 through 55-50 contain the following comprehensive example illustrating the
calculation of diluted EPS:
ASC 260-10
Example 1: Computation of Basic and Diluted EPS and Income Statement Presentation
55-38 This Example illustrates the quarterly and annual computations of basic and diluted EPS in the year 20X1
for Entity A, which has a complex capital structure. The control number used in this Example (and in Example 2)
is income from continuing operations. Paragraph 260-10-55-49 illustrates the presentation of basic and diluted
EPS on the face of the income statement. The facts assumed are as follows:
- Average market price of common stock. The average market prices of common stock for the calendar-year 20X1 were as follows.
- The average market price of common stock from July 1 to September 1, 20X1 was $71.
- Common stock. The number of shares of common stock outstanding at the beginning of 20X1 was 3,300,000. On March 1, 20X1, 100,000 shares of common stock were issued for cash.
- Convertible debentures. In the last quarter of 20X0, 4 percent convertible debentures with a principal amount of $10,000,000 due in 20 years were sold for cash at $1,000 (par). Interest is payable semiannually on November 1 and May 1. Each $1,000 debenture is convertible into 20 shares of common stock. No debentures were converted in 20X0. The entire issue was converted on April 1, 20X1, because the issue was called by Entity A.
- Convertible preferred stock. In the second quarter of 20X0, 600,000 shares of convertible preferred stock were issued for assets in a purchase transaction. The quarterly dividend on each share of that convertible preferred stock is $0.05, payable at the end of the quarter. Each share is convertible into one share of common stock. Holders of 500,000 shares of that convertible preferred stock converted their preferred stock into common stock on June 1, 20X1.
- Warrants. Warrants to buy 500,000 shares of common stock at $60 per share for a period of 5 years were issued on January 1, 20X1. All outstanding warrants were exercised on September 1, 20X1.
- Options. Options to buy 1,000,000 shares of common stock at $85 per share for a period of 10 years were issued on July 1, 20X1. No options were exercised during 20X1 because the exercise price of the options exceeded the market price of the common stock.
- Tax rate. The tax rate was 40 percent for 20X1.
55-39 The following table illustrates the income (loss) from continuing operations.
55-40 The following tables illustrate calculation of basic EPS for the first quarter.
55-41 The following table illustrates calculation of diluted EPS for the first quarter.
55-42 The following tables illustrate calculation of basic EPS for the second quarter.
55-43 The following table illustrates calculation of diluted EPS for the second quarter.
55-44 The following tables illustrate calculation of basic EPS for the third quarter.
55-45 The following tables illustrate calculation of diluted EPS for the third quarter.
Note that the incremental shares from assumed conversions are included in computing the diluted per-share
amounts for the discontinued operation and net loss even though they are antidilutive. This is because the
control number (income from continuing operations, adjusted for preferred dividends) was income, not a loss.
(See paragraphs 260-10-45-18 through 45-19.)
55-46 The following tables illustrate calculation of basic and diluted EPS for the fourth quarter.
Note that the incremental shares from assumed conversions are not included in computing the diluted
per-share amounts for net loss because the control number (net loss adjusted for preferred dividends) was a
loss, not income. (See paragraphs 260-10-45-18 through 45-19.)
55-47 The following tables illustrate calculation of basic EPS for the full year 20X1.
55-48 The following tables illustrate calculation of diluted EPS for the full year 20X1.
55-49 The following table illustrates how Entity A might present its EPS data on its income statement. Note that
the per-share amount for the discontinued operation is not required to be shown on the face of the income
statement.
55-50 The following table includes the quarterly and annual EPS data for Entity A. The purpose of this table
is to illustrate that the sum of the four quarters’ EPS data will not necessarily equal the annual EPS data. This
Subtopic does not require disclosure of this information.
Chapter 5 — Two-Class Method
Chapter 5 — Two-Class Method
5.1 Background
This chapter discusses the calculation of EPS by using the two-class method,
which is an earnings allocation formula under which an entity (1) treats a
participating security as having rights to earnings that otherwise would have been
available to common shares and (2) establishes the entitlement to earnings (or
absorption of losses) of multiple classes of common stock. The two-class method
applies to both basic and diluted EPS. Potential common shares or common shares
exchangeable into other classes of common stock are subject to the two-class method
of calculating diluted EPS if the effect is more dilutive than the application of
another dilutive method of calculating diluted EPS (i.e., the treasury stock,
reverse treasury stock, if-converted, or contingently issuable share method).
See Chapter 9 for discussion of presentation and disclosure requirements related to situations in
which an entity has participating securities or multiple classes of common stock and uses the two-class
method to calculate EPS.
5.2 Scope
5.2.1 General
ASC 260-10
Participating Securities and the Two-Class Method
45-59A The capital structures of some entities include:
- Securities that may participate in dividends with common stocks according to a predetermined formula (for example, two for one) with, at times, an upper limit on the extent of participation (for example, up to, but not beyond, a specified amount per share)
- A class of common stock with different dividend rates from those of another class of common stock but without prior or senior rights.
45-60A All securities that meet the definition of a participating security, irrespective of whether the securities
are convertible, nonconvertible, or potential common stock securities, shall be included in the computation of
basic EPS using the two-class method.
ASC 260-10-45-59A and ASC 260-10-45-60A specify that the two-class method of calculating EPS applies
to both participating securities and a “class of common stock with different dividend rates from those of
another class of common stock but without prior or senior rights.” Section 5.3 discusses the definition
of a participating security, and Section 5.4 addresses when an entity must apply the two-class method
because it has multiple classes of common stock.
5.2.2 Entities That Do Not Pay Dividends
Some entities do not regularly pay dividends on common stock. Other entities that do regularly pay
such dividends may not have declared any dividends during a financial reporting period. Even if an entity
does not intend to declare dividends on common stock or did not declare a current-period dividend
and therefore has no distributed earnings, the entity must still apply the two-class method of calculating
EPS if it has participating securities or multiple classes of common stock. Further, such an entity must
allocate current-period undistributed earnings between common shareholders and participating
security holders on the basis of the contractual rights of each security, as if all the earnings for the
period have been distributed.
The terms of covenants associated with debt or equity securities may require entities to obtain approval
from a third party before they can declare and pay dividends on common stock. Similarly, under
regulatory requirements, an entity may need to obtain approval from a regulator before it can declare
and pay dividends on common stock. Because ASC 260 requires an assumption that all earnings for the
period are distributed when an entity has participating securities or multiple classes of common stock,
the entity must apply the two-class method in such cases regardless of whether it has received approval
during the period to declare and pay dividends on common stock.
5.3 Definition of a Participating Security
5.3.1 General
ASC 260-10 — Glossary
Participating Security
A security that may participate in undistributed earnings with common stock, whether that participation is
conditioned upon the occurrence of a specified event or not. The form of such participation does not have to
be a dividend — that is, any form of participation in undistributed earnings would constitute participation by
that security, regardless of whether the payment to the security holder was referred to as a dividend.
The definition of a participating security is broad and encompasses securities that participate
in undistributed earnings in any form provided that the security participates in its current form.
Participation does not necessarily need to be in the form of a dividend. Any participation in the
undistributed earnings of an entity would constitute participation by a security, regardless of whether
a cash payment is, or would be accounted for as, a dividend (see Example 5-1). A security need not
participate on a 1:1 basis with common stock to be a participating security. A security that participates
only after common shareholders have received a specified amount of dividends or that participates up
to a cap, or on the basis of a specified threshold, would constitute a participating security.
The definition includes securities that participate in dividends on common stock only upon the
occurrence of a specified event. However, if the participation rights are not objectively determinable
or are objectively determinable but the event that results in participation has not occurred, no
undistributed earnings would be allocated to the security. Similarly, undistributed earnings are
not allocated to a security unless it participates on a nondiscretionary basis. See Section 5.3.2 for
further discussion of how the two-class method is applied when a security participates only upon the
occurrence of specified events or on a discretionary basis.
The determination of whether a security is a participating security to which an entity must apply the
two-class method of calculating EPS depends neither on the contract’s classification for accounting
purposes as an asset, liability, or equity instrument nor on the subsequent measurement of the contract
at amortized cost, fair value, or another measurement attribute. However, as discussed in Sections
5.5.2.1 and 5.5.4, the contract’s classification and resulting subsequent-measurement attribute may
affect how the two-class method is applied to calculate EPS.
The table below discusses whether instruments typically included in capital
structures are considered participating securities. In this table, it is assumed
that the instrument’s participation feature is nondiscretionary and objectively
determinable. The remaining discussion in Section 5.3 focuses on additional
considerations relevant to the instruments discussed in this table as well as
other participation-type features and instruments.
Table 5-1
Instrument | Form of “Participation” | Is the
Instrument a
Participating
Security? | Additional
Discussion |
---|---|---|---|
Debt instruments | Potential participation is paid in cash or the
contractual maturity amount is increased
according to a formula tied to dividends on
common stock. | Yes | |
Preferred stock | Potential participation is paid in cash
according to a formula tied to dividends on
common stock. | Yes | |
Holders of preferred stock are entitled to
receive a current-period dividend before
holders of common stock can be paid
dividends. | No | ||
Convertible debt | Potential participation is paid in cash or the
contractual maturity amount is increased
according to a formula tied to dividends on
common stock. | Yes | |
Potential participation is achieved through
a reduction of the conversion price or an
increase in the conversion ratio. | No | ||
Convertible preferred
stock | Potential participation is paid in cash
according to a formula tied to dividends on
common stock. Preferred stockholders may
also be entitled to a stated return in addition
to the dividend participation. | Yes | |
Potential participation is achieved through a reduction of the conversion price
(i.e., an increase in the conversion ratio). | No | ||
Options or warrants to
sell common stock | Potential participation is paid in cash
according to a formula tied to dividends on
common stock. | Yes | |
Potential participation is achieved through
a reduction of the exercise price or an
increase in the number of shares issued
upon exercise. | No | ||
Forward contract to sell
common stock | Potential participation is achieved through a
reduction of the forward price or an increase
in the number of shares under the forward
contract. | It depends.
A facts-and-circumstances
analysis must be
performed. | |
A formula is used to adjust the forward price
and the number of shares under the forward
contract, depending on the market price of
the stock on the date the forward contract is
settled. | It depends.
A facts-and-circumstances
analysis must be
performed. |
See Section 8.9 for
discussion of when incentive distribution rights issued by an MLP represent a
participating security.
5.3.2 Participation Upon Contingent Events or Terms That Are Discretionary or Not Objectively Determinable
ASC 260-10
Participating Securities and Undistributed Earnings
55-26 If a participating security provides the holder with the ability to participate with the holders of common
stock in dividends declared contingent upon the occurrence of a specified event, the occurrence of which is
subject to management discretion or is not objectively determinable (for example, liquidation of the entity or
management determination of an extraordinary dividend), then the terms of the participating security do not
specify objectively determinable, nondiscretionary participation rights; therefore, undistributed earnings would
not be allocated to the participating security.
55-27 If a participating security provides the holder with the ability to participate with the holders of common
stock in earnings for a period in which a specified event occurs, regardless of whether a dividend is paid during
the period (for example, achievement of a target market price of a security or achievement of a certain earnings
level), then undistributed earnings would be allocated to common stock and the participating security based
on the assumption that all of the earnings for the period are distributed. Undistributed earnings would be
allocated to the participating security if the contingent condition would have been satisfied at the reporting
date, irrespective of whether an actual distribution was made for the period.
55-29 If a participating security provides the holder with the ability to participate in extraordinary dividends
and the classification of dividends as extraordinary is within the sole discretion of the board of directors,
then undistributed earnings would be allocated only to common stock. Since the classification of dividends
as extraordinary is within the sole discretion of the board of directors, undistributed earnings would not be
allocated to the participating security as the participation in the undistributed earnings would not be objectively
determinable.
ASC 260-10-55-26 and ASC 260-10-55-29 indicate that undistributed earnings should be allocated to a
security only if the terms of the security specify objectively determinable, nondiscretionary participation
rights. While the guidance refers to a security that participates in earnings on a basis that either is not
objectively determinable or is discretionary as a “participating security,” there would be no impact on the
calculation of diluted EPS for such securities. However, the disclosure requirements in ASC 260-10-55-24
must be considered in such circumstances.
ASC 260-10-55-27 further clarifies that, although the right of a security to participate only upon the
occurrence of a specified event that is objectively determinable and nondiscretionary represents a
participation right, undistributed earnings would be allocated to the participating security during a
financial reporting period only if the contingent condition was satisfied as of the reporting date. This
guidance is consistent with that applied to calculate diluted EPS under the contingently issuable share
method, as discussed in Section 4.5.
5.3.2.1 Equity Restructurings
The ASC master glossary defines an equity restructuring as a “nonreciprocal
transaction between an entity and its shareholders that causes the per-share
fair value of the shares underlying an option or similar award to change,
such as a stock dividend, stock split, spinoff, rights offering, or
recapitalization through a large, nonrecurring cash dividend.” Potential
common shares in the form of options, warrants, or convertible securities
often contain contractual antidilution provisions related to cash payments
or adjustments to the terms of an instrument in the event of an equity
restructuring. Such features do not cause the instrument to represent a
participating security. Rather, an equity restructuring should generally
affect only the outstanding shares (i.e., the denominator) in an entity’s
calculation of EPS. This guidance is consistent with the guidance in ASC
260-10-55-12 on stock dividends and stock splits, which requires an
adjustment to the denominator but no adjustments to the numerator. Section 8.2.1 further
discusses the impact on EPS of a stock split, reverse stock split, or stock
dividend.
5.3.3 Application to Specific Instruments
5.3.3.1 Debt Instruments
A debt instrument, whether convertible or nonconvertible, may include a stated interest rate and allow
holders to participate in dividends on common stock according to a specified formula. Provided that
the participation is objectively determinable and nondiscretionary, the debt instrument represents
a participating security. In applying the two-class method, an entity generally does not allocate any
distributed earnings to the debt instrument because the distributed earnings have been recognized as
interest costs. However, the two-class method should be used to allocate undistributed earnings to the
participating debt instrument. See further discussion in Section 5.5.2.
5.3.3.2 Preferred Stock
The impact on EPS of dividends on preferred stock depends on whether the
preferred stock instrument is a participating security. If preferred stock
meets the definition of a participating security, an entity must apply the
two-class method to calculate EPS, which reduces EPS attributable to common
shareholders because of the allocation of undistributed earnings to the
preferred stock. For preferred stock that does not meet the definition of a
participating security, only dividends declared in the period (whether or
not paid) and dividends accumulated for the period on cumulative preferred
stock (whether or not earned) reduce net income in the calculation of income
available to common stockholders.1 As explained in the (nonauthoritative) guidance in AICPA Technical
Q&As Section 4210.04, if preferred stock dividends are noncumulative,
“only the dividends declared should be deducted [from net income].”
Therefore, dividends on noncumulative preferred stock that does not meet the
definition of a participating security should not affect the calculation of
EPS in financial reporting periods for which dividends have not been
declared or otherwise paid.
Questions have arisen regarding whether preferred stock should be considered a
participating security merely because preferred dividends must be paid
before dividends can be paid on common stock. In particular, all accumulated
dividends on cumulative preferred stock, as well as the current-period
dividends on noncumulative preferred stock, must be paid before dividends
can be paid on common stock. Some may believe that when an entity is
evaluating whether preferred stock is a participating security, it should
assume that all earnings for the period are distributed; therefore, all
preferred stock instruments are participating securities because they will
receive an allocable share of such distributions on the basis of the
preferred stock’s stated dividend rate. However, the mere preference in
dividends does not cause all preferred stock instruments to represent
participating securities. Rather, for preferred stock to meet the definition
of a participating security, it must have a contractual right to participate
with common shareholders in the amount of undistributed earnings. In other
words, an entity should determine whether preferred stock is a participating
security on the basis of the contractual rights to share or participate in
dividends on common stock and not on the basis of the right of preference in
distributions (i.e., the right to receive dividends before dividends can be
paid on common stock). To apply the two-class method of calculating EPS, an
entity must assume that all earnings for the period are distributed;
however, this assumption is only necessary if the entity concludes that a
preferred stock instrument is a participating security because the
instrument shares in distributions when dividends are paid on common stock.
See Examples
5-2, 5-3, and 5-4 for illustrations of this concept.
See Section 5.5.2.5.1 for additional discussion of the application of the two-class method to preferred
stock instruments that meet the definition of a participating security.
5.3.3.3 Convertible Securities
5.3.3.3.1 General
ASC 260-10
Participating Securities and the Two-Class Method
45-62 Dividends or dividend
equivalents transferred to the holder of a
convertible security in the form of a reduction to
the conversion price or an increase in the
conversion ratio of the security do not represent
participation rights. This guidance applies
similarly to other contracts (securities) to issue
an entity’s common stock if these contracts
(securities) provide for an adjustment to the
exercise price that is tied to the declaration of
dividends by the issuer. The scope of the guidance
in this paragraph excludes forward contracts to
issue an entity’s own equity shares.
A reduction in the conversion price, or an increase in the conversion rate, of a
nonmandatorily convertible security on the basis of dividends declared
on an entity’s common stock does not represent participation in earnings
and therefore does not cause a convertible security to meet the
definition of a participating security. Such convertible securities are
unlike other participating securities that ensure their holders’
participation if undistributed earnings were distributed. The holder of
a convertible security cannot benefit from a reduced conversion price
(or increased conversion rate) if the instrument is not converted. Thus,
the participation right is contingent on the conversion of the
convertible security. Adjustments to the conversion price or conversion
rate of a convertible security that result from antidilution features
(e.g., upon a stock split, a stock dividend, or an equity restructuring)
or down-round features would also generally not qualify as participation
in earnings. However, the guidance on down-round features in convertible
preferred stock (see ASC 260-10-25-1, ASC 260-10-30-1, ASC 260-10-35-1,
and ASC 260-10-45-12B) applies if the down-round feature is triggered
(see Section 3.2.2.5.1. The
guidance on down-round features does not apply to convertible debt
instruments.
5.3.3.3.2 Mandatorily Convertible Securities
An entity may have issued instruments that are mandatorily convertible into common stock. These
instruments could include preferred stock or debt that is mandatorily convertible into common stock
at a future date or common stock that is mandatorily convertible into another class of common stock
at a future date. Although conversion into shares of common stock will occur upon the mere passage
of time, the outstanding shares of common stock included in the denominator in the calculation of
basic EPS should be determined on the basis of the current form of the instrument. Therefore, shares
of common stock underlying a mandatorily convertible preferred stock or debt instrument should
not be included in the denominator in the calculation of basic EPS; however, the two-class method of
calculating basic EPS is required if the mandatorily convertible instrument meets the definition of a
participating security. Similarly, shares of a second class of common stock underlying a mandatorily
convertible common stock instrument should not be included in the outstanding shares of the second
class of common stock. However, the mandatorily convertible common stock instrument is considered
a class of outstanding common stock. In such circumstances, an entity is required to apply the two-class
method of calculating EPS.
A mandatorily convertible security would meet the definition of a participating security if the holder
is entitled to participate in (benefit from) dividends declared on an entity’s common stock through a
(1) receipt of cash dividends or (2) reduction of the conversion price or increase in the conversion rate.
The guidance in ASC 260-10-45-62 does not apply to mandatorily convertible securities; rather, for such
securities, an entity should apply the guidance applicable to forward contracts to sell common stock.
Connecting the Dots
Some securities that are mandatorily convertible on a fixed or
determinable date also contain call or put options that allow
the issuer or holder to settle the security at an amount other
than the if-converted value (e.g., an option that allows the
issuer to call the security for its principal or par amount). In
these circumstances, the entity must evaluate whether it is at
least reasonably possible that such an option would be
exercised. If exercise is reasonably possible, the security is
accounted for as a nonmandatorily convertible security (see
Section 5.3.3.3.1).
However, if the option is determined to be nonsubstantive, the
instrument would be accounted for as a mandatorily convertible
security. An entity must exercise professional judgment in
making this determination. Careful attention should be given to
(1) contingently exercisable call or put options and (2) the
pricing of the conversion feature compared with the call or put
option.
5.3.3.3.3 Increase in Liquidation Preference of Convertible Preferred Stock
A convertible preferred security that participates in dividends on common stock
on an as-converted basis through an increase in its liquidation
preference meets the definition of a participating security unless such
an increase results in a contingent transfer of value to the holder. For
example, if the increase in the liquidation preference would affect the
instrument upon its conversion, redemption, or settlement in a
liquidation of the issuer, the value transferred is noncontingent
because the holder would, in all circumstances, benefit from the
increase in the liquidation preference (i.e., there is no possible
settlement in which the holder would not benefit). If, however, the
increase in the liquidation preference would not affect the monetary
value of the security in a settlement scenario whose occurrence is at
least reasonably possible, the instrument would not represent a
participating security because the transfer of value is contingent
(e.g., if the increase in the liquidation preference affects the
conversion price only, the instrument would not be a participating
security because it could be redeemed instead of being converted). This
guidance is consistent with that on adjustments to the conversion price
of a nonmandatorily convertible security (i.e., because the holder’s
ability to benefit from this adjustment is contingent, the instrument is
not a participating security).
In addition to considering whether the convertible preferred stock is a
participating security, an entity should assess whether any increase in
the liquidation preference that results from dividends declared on
common stock could affect the measurement of the preferred stock (e.g.,
redeemable preferred stock subject to remeasurement under ASC
480-10-S99-3A) and may be treated as a dividend on preferred stock. See
Sections
3.2.2.2.6 and 3.2.2.4 for further
discussion.
5.3.3.4 Options and Warrants to Sell Common Stock
ASC 260-10-45-62 applies to options and warrants to sell common stock under which the counterparty
has a right, but not an obligation, to purchase an entity’s common stock. In accordance with ASC 260-10-45-62, dividends or dividend equivalents transferred to a holder of an option or warrant in the form of a
reduction to the exercise price or an increase in the number of common shares issuable upon exercise
do not represent participation rights. Thus, regardless of whether the exercise price is reduced (or
the number of common shares received on exercise is increased) on the basis of actual or anticipated
dividends, the option or warrant does not represent a participating security. An option or warrant would
be a participating security if the holder is entitled to participate in dividends on an entity’s common stock
through the receipt of a cash payment, provided that the realization of such dividend rights does not
depend on whether the option or warrant is exercised. See Examples 5-5 and 5-6 for illustrations of this
concept.
See Section 3.2.5.3 for discussion of the impact on EPS of situations in which the exercise price of an
option or warrant to sell common stock is adjusted as a result of a down-round provision.
5.3.3.5 Forward Sale Contracts
5.3.3.5.1 General
ASC 260-10
Participating Securities and the Two-Class Method
45-63 In a forward contract
to issue an entity’s own equity shares, a
provision that reduces the contract price per
share when dividends are declared on the issuing
entity’s common stock represents a participation
right. Such a provision constitutes a
participation right because it results in a
noncontingent transfer of value to the holder of
the forward contract for dividends declared during
the forward contract period. That is, the forward
contract holder has a right to participate in the
undistributed earnings of the issuing entity
because a dividend declaration by the issuing
entity results in a transfer of value to the
holder of the forward contract through a reduction
in the forward purchase price per share. Because
that value transfer is not contingent — as opposed
to a similar reduction in the exercise price of an
option or warrant — the forward contract is a
participating security, regardless of whether,
during the period the contract is outstanding, a
dividend is declared.
An entity may enter into a forward sale contract to issue its common shares on a
stand-alone basis as a means of raising equity capital that is needed in
the future, as part of an accelerated share repurchase agreement, or in
conjunction with a unit offering. The forward price in the forward
contract may be subject to adjustment upon the occurrence of various
conditions or events, including, but not limited to, stock dividends,
stock splits or reverse stock splits, cash dividends, mergers or other
fundamental changes, increased hedging costs, other dilutive or
concentrating events, the entity’s common stock price, interest rates,
or the mere passage of time. The determination of whether an adjustment
to the forward price of a forward sale contract constitutes a
participation right that causes the contract to meet the definition of a
participating security depends on the nature of the adjustment. Such an
adjustment also affects the entity’s evaluation of whether the forward
sale contract meets the conditions in ASC 815-40 to be indexed to the
entity’s stock and classified in stockholders’ equity, as discussed in
Deloitte’s Roadmap Contracts on an Entity’s Own Equity. However, as
discussed in Section
5.3.1, the classification of a forward sale contract as
an asset, liability, or equity instrument does not affect whether the
contract is a participating security.
A forward sale contract is a participating security if it contains a provision that automatically reduces
the forward price when the entity declares (1) any dividends on its common stock or (2) dividends on its
common stock that exceed a stated level. In these circumstances, the reduction to the forward price is
objectively determinable and nondiscretionary on the basis of the entity’s declaration of dividends on its
common stock and varies depending on whether dividends are declared or on the amount of declared dividends. This conclusion is premised on the notion that a reduction to the forward price in a forward
sale contract represents a noncontingent transfer of value to the holder because the contract must
be settled on a future date or dates. Unlike exercise or conversion price adjustments in an option or
convertible security, the transfer of value from a forward price reduction is not contingent on the actions
of the holder; therefore, the entity must treat the contract as a participating security.
However, some forward sale contracts contain mechanisms or formulas that may result in a reduction
to the forward price that does not constitute participation under ASC 260-10-45-59A through 45-70.
ASC 260-10-45-65 states, in part, “If the terms of the participating security do not specify objectively
determinable, nondiscretionary participation rights, then undistributed earnings would not be allocated
based on arbitrary assumptions.” Thus, forward sale contracts that contain terms permitting dividend
participation under certain conditions do not represent participating securities when the participation
terms are (1) not objectively determinable or (2) discretionary. Even if an adjustment to the terms
of a forward sale contract is objectively determinable and nondiscretionary, an entity must evaluate
additional considerations in determining whether the mechanism or formula that results in a reduction
to the forward price constitutes participation in dividends under ASC 260.
5.3.3.5.2 Fixed Reductions to Forward Price Based on Anticipated Dividends
Some forward sale contracts that may be settled at the option of the entity or counterparty before the
stated final maturity date contain fixed reductions to the forward price that occur over the contract’s
term and are designed to mirror the anticipated dividends that the entity is expected to declare on its
common stock. When adjustments to the forward price are fixed at the inception of the contract and do
not depend on actual dividends paid or earnings of the entity, the forward contract is not a participating
security as defined in ASC 260.
ASC 260-10-45-63 states, in part, that “a provision that reduces the contract
price per share when dividends are declared on
the issuing entity’s common stock represents a participation right”
(emphasis added). A contract term that reduces the forward price by a
fixed amount on anticipated dividend dates is not a participation
feature because the reduction in the forward price is fixed at the
inception of the contract and does not depend on (or vary with) actual
dividends paid to common shareholders. The following “fixed” settlement
terms would also not cause a forward sale contract to represent a
participating security — provided that no payments or adjustments are
made — if, on an expected dividend date, the entity does not declare
dividends or declares dividends on its common stock that are more or
less than expected amounts:
-
A single forward price is established at inception (with no subsequent adjustments) to reflect the expected dividends that will be distributed during the period of the forward sale contract.
-
At inception of the contract, the entity is required to make a fixed cash payment to the counterparty; this payment is equal to the present value of dividends that are expected to be remitted over the term of the forward sale contract (“prepaid dividends”).
-
The forward sale contract requires the entity to make a fixed cash payment upon settlement rather than at inception (as illustrated in the previous bullet). This fixed payment is determined at inception on the basis of the dividends that are expected to be remitted over the term of the forward sale contract and does not vary according to actual dividends paid.
-
The entity is required to make periodic fixed cash payments to the counterparty throughout the term of the forward sale contract on dates that correspond to the expected dividend distribution dates. The payments are fixed at inception and do not vary according to actual dividends paid.
Forward price adjustments or payments that are not fixed at the inception of a forward sale contract
and are subject to adjustment on the basis of the amount of dividends declared by the entity on its
common stock represent participating securities in accordance with ASC 260-10-45-63.
In some situations, the counterparty is permitted to terminate the forward sale contract early and
share-settle it at its current fair value on the date the entity declares a dividend greater than a specified
amount. This feature is intended to protect the counterparty from the negative impact that unexpected
dividends can have on the fair value of the forward sale contract. Such a feature is not a participation
feature under ASC 260 because the settlement amount (i.e., the fair value of the forward sale contract
as of the date of the dividend declaration) does not vary with the amount of dividends declared by the
entity. Therefore, when a forward sale contract with fixed forward price reductions on expected dividend
dates allows the counterparty to settle the contract early if the entity declares, on a periodic dividend
declaration date, a dividend that is greater than the fixed reduction on that date under the contract’s
terms, the contract does not represent a participating security.
5.3.3.5.3 Forward Contract to Issue a Variable Number of Common Shares
The evaluation of whether a forward contract to issue a variable number of
common shares is a participating security can be more complex than the
evaluation of fixed-price forward sale contracts. A more complex, yet
fairly common, forward sale contract is a variable share forward (VSF)
sale contract, which is often issued in conjunction with a unit offering
that also includes a debt or preferred security but may also be issued
on a stand-alone basis. For discussion of the implications of VSF
contracts and unit structures with respect to diluted EPS, see Section 4.2.2.1.1
(and Example
4-3) and Section 4.8.3.6.
Connecting the Dots
In accounting for a unit structure that includes a VSF contract, an entity must
consider whether the debt or preferred security (the “security”)
and the VSF contract represent a single unit or two units of
account. The determination of the unit of account can affect the
classification of the unit structure as a liability or equity
instrument, which in turn will affect the subsequent measurement
and EPS accounting. The components in a unit structure are
typically considered separate units of accounting because the
counterparty has the right to transfer the security and VSF
contract independently and there is substance to the separation
of the contracts. In these situations, the entity must determine
the classification of the security and the VSF contract for
accounting purposes, which will affect the allocation of
proceeds to the separate instruments. The classification of the
VSF contract as a liability or equity instrument will also have
an impact on the accounting for diluted EPS, which, as discussed
in Section
4.8.3.6, should be determined by using the
treasury stock or if-converted method depending on the facts and
circumstances. If the contract is classified as a liability
instrument, the entity may need to adjust the numerator in
accordance with the guidance in ASC 260 on contracts that may be
settled in cash or stock (see Section 4.7.3). If the VSF
contract is a participating security, the entity must (1) apply
the two-class method to the VSF contract in calculating basic
EPS and (2) determine the more dilutive of the (a) treasury
stock method or if-converted method as applicable or (b)
two-class method of calculating diluted EPS.
In a VSF contract, the number of common shares issued on settlement depends on
the price of the entity’s common stock. The terms of a typical VSF
contract might require settlement in the manner illustrated in the table
below. In this table, it is assumed that the counterparty pays $100 in
cash as of the settlement date and that the fair value of the entity’s
common stock as of the trade date is also $100 per share.
Table 5-2
Entity’s Common Stock
Price as of Reference
Date of Contract
Settlement | Number of Common
Shares Counterparty
Receives | Observations |
---|---|---|
Below $100 | One share of stock | The counterparty is exposed to declines in the price of the issuer’s stock below
$100. |
Above $100 but below
$120 (the original range) | A number of shares equal
in value to $100 | The counterparty neither benefits nor loses as the
price of the common stock changes within the price
range. |
$120 or more | 0.8333 shares | The counterparty participates in a portion of the appreciation of the issuer’s
stock above $120. The counterparty does not
receive full participation since it receives less
than one share of the entity’s common stock. |
Typically, a VSF contract has an intermediate term (e.g., three to five years). Many VSF contracts also
contain antidilution provisions that are designed to compensate the counterparty for increases in
dividends that occur during the term of the contract. However, the counterparty will receive no benefit
for increases in dividends if the VSF contract is settled within a calculable range (the final range, which,
as discussed below, is not necessarily the same as the original range).
The original range and final range are often identical if no dividend increases
occur during the term of the VSF contract. However, under the terms of
many VSF contracts, the final range is reduced as dividends increase.
For example, according to the terms of the VSF contract described in the
table above, the original range of the common stock price is $100 to
$120. If the entity increases its normal quarterly dividends by $4
during the term of the VSF contract, the contract would not entitle the
counterparty to a dividend benefit if the common stock price used for
settlement of the contract is between $100 and $116, the final range.
The calculation of the final range depends on the antidilution formula
described in the contract for each VSF. In the context of this section,
the dividend benefit represents the incremental value received by the
counterparty compared with the benefit that the counterparty would have
received if no adjustment had been made for increases in dividends.
The determination of whether a VSF contract includes a participation right and, thus, whether the entity
is required to use the two-class method to calculate EPS, will depend on the relevant terms of the VSF
contract. Some VSF contracts contain a participation mechanism or formula that does not constitute
participation under ASC 260-10-45-59A through 45-70. Other VSF contracts potentially participate in
dividends depending on the entity’s common stock price that is used to calculate the settlement of the
VSF contract.
See Section 5.5.2.5.3A for discussion of application of the two-class method of calculating EPS to a VSF contract that represents a participating security because it is not at least reasonably possible that the contract ultimately will be settled within the final range.
5.3.3.5.3.1 VSF Contracts Whose Participation Formula Does Not Constitute Participation
Some VSF contracts contain terms that permit a type of dividend participation that does not cause
such contracts to represent participating securities. As discussed in ASC 260-10-45-65, a key factor
related to determining whether a VSF contract is a participating security is whether the terms of the
security specify “objectively determinable, nondiscretionary participation rights.” Participation in only
extraordinary dividends through an adjustment to the common stock prices used in the determination
of the range for settlement purposes cannot represent a participation feature unless an extraordinary
dividend is objectively defined. Example 5-11 illustrates a VSF contract that participates only in
extraordinary dividends.
In other situations, the compression of the original range as a result of
dividends declared by the entity on its common stock will not
benefit the counterparty upon settlement. That is, regardless of the
compression of the original range, the counterparty does not benefit
from dividends declared by the entity. See the next section for more
information about how to make this determination at inception of a
VSF contract.
5.3.3.5.3.2 Evaluating the Participation Formula in VSF Contracts
If a VSF contract contains a participation formula that results in compression
of the original range when the entity declares dividends on its
common stock, the entity must identify a range of share prices used
to determine the settlement of the contract within which the
counterparty will not benefit from dividends on the entity’s common
stock during the term of the contract. If, at inception of the
contract, it is at least reasonably possible that the share price
used to determine settlement will be within this identified range
and other conditions are met, the VSF contract will not be
considered a participating security.2 In performing this analysis, an entity often must
qualitatively evaluate outcomes. However, a quantitative evaluation
and involvement of a specialist may be appropriate in other
instances.
If both of the following conditions are met, a VSF contract is not considered a participating security:
- The VSF contract does not entitle the counterparty to participate in dividends if it is settled within the final range.
- At the inception of the VSF contract, it is at least reasonably possible that the contract ultimately will be settled within the final range.
The first condition is factual and depends on the specific terms of the contract. Typically, the final range
of a VSF contract is reduced as dividends are paid or are increased during the term of the contract.
However, this may not be the case for certain VSF contracts. If the VSF contract entitles the counterparty
to dividends, payable in cash, when the entity declares dividends on its common stock, the contract
would be a participating security. If, on the other hand, the terms of the VSF contract do not entitle the
counterparty to any possible benefits when the entity declares dividends on its common stock (i.e.,
the counterparty does not receive dividends in cash or through any adjustment to the terms of the
contract), the VSF contract would not be a participating security.
In applying the second condition, an entity must exercise professional judgment
and perform a scenario analysis of future expected dividends
during the term of the contract. In the context of this evaluation,
ASC 450-20-20 defines reasonably possible as “[t]he chance of the
future event or events occurring is more than remote but less than
likely.” While not a bright line, “reasonably possible” generally
connotes a likelihood of 10 percent or more.
In evaluating whether settlement of the contract within the final range is reasonably possible, an entity
should consider factors such as the following:
- The terms of the VSF contract, including its maturity date and the formula for adjustments to the original range.
- The volatility of the underlying common stock.
- The relationship between (1) the price of the common stock on the date the VSF contract is entered into and (2) the low and high end of the original range.
- Historical and expected dividend levels.
With respect to the factor in the third bullet above, there is no bright line regarding the appropriate
extent of the difference between the low end of the range and the high end of the original and expected
final range. In some situations, an entity may only need to perform a qualitative evaluation to determine
that the VSF contract is not a participating security. (See Example 5-12 for an illustration of this notion.)
In other circumstances, an entity may need to perform a quantitative financial analysis to determine
whether it is at least reasonably possible that the VSF contract will be settled within the final range (i.e.,
the original range after adjustment for expected dividends). An entity should consider consulting with a
specialist when performing such an analysis, especially if the entity’s common stock is highly volatile or a
meaningful change in dividends is expected during the term of the VSF contract.
An entity can perform the following steps to determine whether a VSF contract is a participating security:
- Assess whether the counterparty to the VSF contract can participate in dividends (i.e., can benefit from dividends declared by the entity on its common stock) under any circumstance. If so, go to step 2. If not, the VSF contract is not a participating security and no further analysis is needed.
- Determine whether the participation feature (e.g., objectively determinable or nondiscretionary rights) is within the scope of ASC 260-10-45-59A through 45-70. If so, go to step 3. If not, the VSF contract is not a participating security and no further analysis is needed.
- Evaluate whether there is a range of share prices that governs the settlement of the VSF contract and does not permit the counterparty to participate in dividends. If so, go to step 4. If there is no such range, the VSF contract is a participating security and no further analysis is needed.
- Analyze whether the original range is narrow enough that it is not at least reasonably possible that the entity’s common stock price would be settled within the original range. If so, the VSF contract is a participating security and no further analysis is needed. If not, go to step 5.
- Determine final ranges by considering a number of reasonably possible final share prices and reasonably possible dividend levels or changes in dividend levels. Evaluate whether it is at least reasonably possible that the VSF contract will be settled within a final range. A qualitative analysis is acceptable if the original range is large, the prospects for significant increases in dividends are remote, and the stock is not highly volatile. If an evaluation of the final ranges indicates that it is not at least reasonably possible that the counterparty to the VSF contract will not receive a dividend benefit (i.e., only in remote circumstances will the counterparty not receive a dividend benefit), the VSF contract is a participating security and the two-class method should be applied.
An entity only needs to evaluate whether a VSF contract is a participating security at the inception of the
contract, unless the contract is subsequently modified, in which case a reassessment is required.
5.3.3.6 Mandatorily Redeemable Common Shares and Forward Contracts to Repurchase Common Shares
ASC 480-10-45-4 addresses the EPS accounting for mandatorily redeemable common shares and
forward repurchase contracts that must be physically settled by repurchase of a fixed number of
common shares in exchange for cash. For these instruments, the common shares subject to redemption
or repurchase are excluded from the denominator in the calculation of EPS. However, if the holder of
the common shares subject to redemption or repurchase is entitled to dividends before the redemption
or repurchase, the entity must apply the two-class method in calculating EPS. See further discussion in
Section 5.5.2.5.3.
5.3.3.7 Share-Based Payment Awards
ASC 260-10
Participating Securities and the Two-Class Method
45-61 Fully vested
share-based compensation subject to the provisions
of Topic 718, including fully vested options and
fully vested stock, that contain a right to receive
dividends declared on the common stock of the
issuer, are subject to the guidance in paragraph
260-10-45-60A.
45-61A Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend
equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of
EPS pursuant to the two-class method under the requirements of paragraph 260-10-45-60A.
Nonvested shares of common stock and nonvested stock options represent
participating securities if the holder has a nonforfeitable right to
participate in dividends or dividend equivalents during the requisite
service period (or nonemployee’s vesting period).3 The share-based payment awards would represent participating
securities only if the holder receives cash when the entity (1) declares
dividends on its common stock and (2) retains such cash even if it forfeits
the award or does not exercise the stock option. If, however, the holder of
a stock option is only entitled to a reduction of the exercise price or an
increase in the number of common shares issuable upon exercise, the stock
option would not be a participating security for the same reason options and
warrants that are only entitled to a dividend benefit in the form of a
reduction of the exercise price or increase in number of common shares
issuable upon exercise are not participating securities (see Section 5.3.3.4). See
Section
7.1.3.1 for further discussion of the application of the
definition of participating security to share-based payment awards.
5.3.3.8 Noncontrolling Interests
NCIs that may meet the definition of a participating security generally will
fall into one of the following categories:
-
NCI in the form of common stock that participates in earnings of the parent.
-
NCI in the form of preferred stock that participates in earnings of the subsidiary.
-
NCI in the form of preferred stock that participates in earnings of the parent.
-
NCI in the form of potential common stock that participates in earnings of the subsidiary.
-
NCI in the form of potential common stock that participates in earnings of the parent.
If the participating NCI is a share-based payment award, see Section 7.1.3.
5.3.3.9 Own-Share Lending
ASC 470-20
Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance
45-2A Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending
arrangement occurs, at which time the loaned shares would be included in the basic and diluted
earnings-per-share calculation. If dividends on the loaned shares are not reimbursed to the entity, any
amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings,
attributable to the loaned shares shall be deducted in computing income available to common shareholders, in
a manner consistent with the two-class method in paragraph 260-10-45-60B.
An entity may loan its shares of common stock to an investment bank or third-party investor in
conjunction with the issuance of convertible debt. Such shares are “loaned” because the investment
bank or investor is unable to borrow shares in the market to hedge its exposure to the conversion
option in the issuer’s convertible debt or because the borrowing cost is prohibitive. Although the
“loaned” shares are legally issued and outstanding, they are generally not considered outstanding shares
of common stock in the calculation of EPS. However, if the borrower of the shares receives dividends
while holding the shares and is not obligated to reimburse them to the entity, the loaned shares
represent participating securities and the two-class method of calculating EPS must be applied. See
Section 8.5 for further discussion of own-share lending arrangements.
5.3.4 Examples
Example 5-1
Debt Instrument With Interest Payment Terms That Vary on the Basis of Dividends Declared on
Common Stock
Entity D issues $10 million of senior notes (the “notes”) that mature 10 years
from the issuance date. The notes pay interest
quarterly, in arrears, at a rate of 2.5 percent per
annum. The holders of the notes are also entitled to
participate in dividends declared on D’s common stock on
a 40:60 basis. The participation feature allows the
holders to receive, in cash, an amount equal to 66.67
percent of all dividends declared and paid to D’s common
stockholders. The notes meet the definition of a
participating security because the holders participate
in undistributed earnings with holders of D’s common
stock. See Example 5-19 for
an illustration of how the two-class method is applied
to the notes.
Example 5-2
Evaluation of Cumulative Preferred Stock
Entity A’s capital structure consists of one class of common stock and one class of cumulative perpetual
preferred stock. The preferred stock has priority over the common stock in liquidation and has a stated
dividend rate of 5 percent. In addition, there are no terms that would result in the preferred stock’s
participation in dividends with common stock. For the current period, A declares a 5 percent dividend on its
preferred stock.
Because the preferred stock does not participate in dividends with common stock (i.e., the preferred
stockholders are only entitled to cumulative dividends on the preferred stock at the stated dividend rate of 5
percent), it does not meet the definition of a participating security. As a result, A should not use the two-class
method to calculate basic and diluted EPS. However, in accordance with ASC 260-10-45-11, A’s calculation of
income available to common stockholders (i.e., the numerator in the calculation of basic EPS) should reflect the
dividends on its preferred stock, regardless of whether they are declared.
Note that because the dividends on preferred stock have been declared for the period, the conclusion above
would be unchanged if the dividends on the preferred stock were noncumulative.
Example 5-3
Evaluation of Cumulative Convertible Preferred Stock
Entity Z’s capital structure consists of one class of common stock and one class of cumulative perpetual
convertible preferred stock. The preferred stock has priority over the common stock in liquidation and is
convertible at any time into Z’s common stock on a 1:1 basis. The preferred stock has a stated cumulative
dividend rate of 8 percent and participates in dividends declared on common stock on an “as if converted”
basis (i.e., holders of the preferred stock are entitled to receive the same dividend that common stockholders
receive). Entity Z did not declare any dividends on common stock or preferred stock during the period.
Because the preferred stock’s “as if converted” dividend feature would result in its participation in dividends
with common stock, the preferred stock meets the definition of a participating security. As a result, Z would
be required to use the two-class method to calculate basic and diluted EPS even though it did not declare and
pay dividends for the period and regardless of whether it ever intends to declare and pay a dividend. Entity
Z should allocate the current-period undistributed earnings between common stockholders and preferred
stockholders on the basis of the contractual rights of each security as if all of the earnings for the period had
been distributed.
In this example, Z should first reduce income from continuing operations (and net income) by the amount of
the stated dividend rate that must be paid for the period (i.e., the unpaid 8 percent cumulative dividend). If Z
has a loss from continuing operations (or a net loss), the loss would be increased by the amount of the stated
dividend that accumulates for the period. Entity Z should then allocate the remaining undistributed earnings
(losses) between the common stock and the preferred stock on the basis of what would happen if all of the
current-period earnings (losses) were distributed. Entity Z should use the resulting earnings allocated to its
common stock to determine basic and diluted EPS for its common stock.
Note that because of the “as if converted” dividend participation feature, the EPS on common stock in this
example would be the same if the stated dividend feature of the preferred stock was noncumulative and either
(1) the noncumulative dividends on the preferred stock for the period were declared or (2) the noncumulative
dividends on the preferred stock for the period were not declared but net income for the period was greater
than or equal to the amount of the stated preferred dividends. When applying the two-class method in such
circumstances, Z would first allocate earnings to the noncumulative preferred stock in the amount of the
stated dividend, regardless of whether the stated dividends were paid, since those dividends must be paid
to the preferred stockholders before any remaining current-period earnings may be distributed between the
common stockholders and the preferred stockholders. The remaining undistributed earnings (losses) would
then be allocated in the same manner as they would according to the original facts in the example.
However, the EPS on common stock would be different if the noncumulative dividends on the preferred stock
were not declared during the period and either (1) the stated dividend on the noncumulative preferred stock
was greater than net income or (2) the entity reported a net loss for the period. In such circumstances, the
amount of dividends (if any) allocated to the noncumulative preferred stock would be limited to net income
reported for the period. That is, if the entity reported net income for the period in an amount equal to or less
than the stated dividend on the noncumulative preferred stock, all of the net income for the period would be
allocated to the noncumulative preferred stock. If the entity reported a net loss for the period, there would
be no allocation of earnings to the noncumulative preferred stock (provided that the holders of the preferred
stock do not have a contractual obligation to share in losses) and the entire net loss for the period would be
allocated to the common stock.
See Section 5.5.2.5.1 for further discussion of the application of the two-class method to participating
preferred stock.
Example 5-4
Evaluation of Noncumulative Preferred Stock
Entity M’s capital structure consists of one class of common stock and one class of noncumulative perpetual
preferred stock. The preferred stock has priority over the common stock in liquidation. In addition, the terms
of the preferred stock stipulate that preferred stockholders must be paid the stated dividend rate of 7 percent
before common stockholders can receive a dividend. The preferred stockholders do not otherwise have rights
to dividends paid to common stockholders.
Although the preferred stockholders must be paid the stated dividend before the common stockholders
receive a dividend, the preferred stock is not considered a participating security because it does not participate
in dividends with common stock. As a result, M should not use the two-class method to calculate basic and
diluted EPS. However, M should deduct from net income any dividends declared during the period (regardless
of whether they were paid during the period) to calculate income available to common stockholders (i.e., the
numerator in the calculation of basic EPS). If there is a net loss, the amount of the loss would be increased by
the amount of those dividends.
Note that if the noncumulative dividends on preferred stock for the period had not been declared, net income
would represent the numerator in the calculation of basic EPS (i.e., the entity would not need to adjust net
income to determine income available to common stockholders).
Example 5-5
Warrants on Common Stock With Yield Rights
Entity J issues warrants to sell common stock that entitle the counterparty to a yield right, payable in cash, equal to 25 percent of the dividends J pays on its common stock for each common share into which the warrants are exercisable. Although the yield right is not labeled as a dividend, it is a participation right because the holder of the warrants is entitled to share in dividends declared on J’s common stock without exercising the warrants. Therefore, the two-class method of calculating EPS must be applied to the warrants. Regardless of whether J declared any dividends during the
period, it must allocate undistributed earnings to the warrants.
Note that, in the above example, the warrants are considered participating
securities regardless of the extent of participation.
That is, because of the holders’ entitlement to any
participation in dividends (i.e., between 1 percent and
100 percent), the warrants meet the definition of a
participating security. However, if dividends paid by an
entity are held in abeyance and paid to a warrant holder
only upon exercise, such warrants would not be
considered a participating security.
Example 5-6
Warrants on Common Stock for Which the Exercise Price Is Adjusted on the Basis of Dividends
Entity K issues warrants to sell common stock that entitle the counterparty to
purchase 100,000 common shares at an exercise price of
$10 per share. Various adjustments may be made to the
exercise price and the number of common shares received
upon exercise, including standard antidilution
adjustments and adjustments based on cash dividends.
With respect to adjustments for cash dividends, the
warrant agreement states that if any cash is distributed
to all or substantially all holders of common stock —
other than a quarterly cash dividend that does not
exceed $0.20 per share, as adjusted for any stock split,
reverse stock split, stock dividend, or similar dilutive
event — the exercise price will be reduced on the basis
of a formula in the warrant agreement. The formula
specifies that the adjustment to the exercise price will
be calculated on the basis of the exercise price before
the adjustment multiplied by the quotient of (1) the
market price of K’s common stock on the last trading day
preceding the first date on which the common stock
trades without the right to receive such distribution
minus the amount of cash dividend in excess of $0.20 and
(2) the market price on this date as specified in
(1).
Although the holder of the warrant is entitled to a benefit when K declares any
quarterly dividend in excess of $0.20 per share, the
warrant is not a participating security in accordance
with ASC 260-10-45-62. The warrant in this example has a
substantive exercise price. See Section
3.3.2.5 and Example 3-31 for
discussion of warrants with nonsubstantive exercise
prices.
Example 5-7
Option on Membership Interests With Rights to Distributions to Meet Tax Obligations
Entity O, an LLC, issues options that entitle the counterparty to purchase
10,000 membership interests at a price of $1,000 per
unit. Because O is an LLC that is taxed as a
partnership, the options contain a provision stipulating
that if O makes cash distributions during an annual
period, those distributions will include a payment to
holders of the options that is equal to any taxable
income from the partnership that results from the
options multiplied by the maximum federal tax rate.
The options meet the definition of a participating security because, if O distributes its earnings, it is required
to make cash distributions to the holders of the options on the basis of the formula specified in the option
agreement. In applying the two-class method, O should allocate undistributed earnings to the options on the
basis of the amount of cash that would be distributed to the option holders, provided that all earnings for the
period were distributed. In doing so, O will reflect an allocation of undistributed earnings to the option holders
on other than a 1:1 basis with common shareholders.
Note that if the option agreement had stated that O’s board of managers had the right, but not the obligation,
to make a cash distribution to the option holders in the event of an adverse tax consequence during an
annual period, this right would represent a participation feature that is not objectively determinable and
nondiscretionary; therefore, no undistributed earnings would be allocated to the options under the two-class
method of calculating EPS.
Example 5-8
Forward Sale Contract With Reduction to Forward Price on the Basis of Extraordinary Dividends —
Contract Does Not Specify Objectively Determinable, Nondiscretionary Participation Rights
Entity A enters into a forward sale contract on its common stock that entitles the counterparty to a dividend
benefit (paid in the form of a reduction in the forward price) related only to extraordinary dividends. The
forward contract defines an extraordinary dividend as one that must be characterized as such by a vote of
the board of directors. Dividends can be paid at any level without being characterized as extraordinary. The
forward contract is not a participating security, and A is not required to use the two-class method because
the contract does not specify objectively determinable, nondiscretionary participation rights since the
determination of whether a dividend qualifies as an extraordinary dividend is subjective.
Conversely, if the terms of the forward sale contract did specify objectively
determinable and nondiscretionary participation rights
pertaining to extraordinary dividends, the contract
would be a participating security under ASC
260-10-45-59A through 45-70. The example below
illustrates this notion.
Example 5-9
Forward Sale Contract With Reduction to Forward Price on the Basis of Extraordinary Dividends —
Contract Specifies Objectively Determinable, Nondiscretionary Participation Rights
Entity B enters into a forward sale contract on its common stock that entitles the counterparty to dividend
benefits (paid in the form of a reduction in the forward strike price) related only to extraordinary dividends.
Extraordinary dividends are defined as those in excess of 200 percent of the prevailing dividend rate as of
the date on which B enters into the forward contract. The participation right is objectively determinable and
nondiscretionary; therefore, the forward sale contract meets the definition of a participating security. As a
result, undistributed earnings would be allocated to the forward contract in periods in which, if all earnings had
been hypothetically distributed, an extraordinary dividend would have resulted.
Example 5-10
Forward Sale Contract With Adjustments to Forward Price on the Basis of Anticipated Dividends
Fixed at Inception
Entity Z enters into an accelerated share repurchase (ASR) agreement with Bank B. Under the guidance in ASC 505-30-25-5 and 25-6, the ASR
agreement comprises two separate transactions: (1) the acquisition of treasury stock and (2) a forward contract
indexed to Z’s stock. The forward sale contract is classified in equity under ASC 815-40.
To facilitate the treasury stock purchased by Z, B borrows Z’s common shares from third parties. Ultimately, B
must return Z’s common shares to those third-party lenders. To obtain the shares, B purchases Z’s common
shares from the open market during the term of the ASR agreement. The prices of those open-market
purchases are used to determine the settlement amount of the forward sale contract between Z and B.
The settlement terms of the forward sale contract are as follows:
- On each day on which B executes a purchase of Z’s common shares in the open market, a daily difference amount will be determined. The daily difference amount equals the number of shares repurchased, multiplied by the difference between (1) the volume-weighted-average price of Z’s common stock on the date of purchase and (2) the forward price specified in the forward sale contract.
- The forward price for each purchase is initially set at the closing price of Z’s common stock at the inception of the ASR agreement. Each day, the forward price is reset to equal the prior day’s forward price, increased by a fixed interest rate. In addition, the forward price is reduced by $0.10 on each of Z’s anticipated quarterly ex-dividend dates. The $0.10 reduction in the forward price is intended to mimic expected future dividend payments to compensate B for the resulting negative impact on Z’s common stock price on those dates. However, the amount of this reduction is fixed and is not contingent on actual future dividend payments by Z.
The final settlement amount (which may be settled in Z’s common shares or cash at Z’s option) is equal to the
sum of all daily difference amounts.
Because the forward price reduction on each anticipated quarterly dividend date is fixed at the inception of
the contract and does not vary according to actual dividends paid or earnings, the forward contract is not a
participating security.
Example 5-11
VSF Contract — Participation Only in Extraordinary Dividends
Entity A enters into a VSF contract that entitles the counterparty to a dividend benefit related only to
extraordinary dividends. The contract defines an extraordinary dividend as a dividend that is characterized
as such by a vote of the board of directors. Dividends can be paid at any level without being characterized
as extraordinary. The VSF contract is not a participating security because it does not specify objectively
determinable, nondiscretionary participation rights since the determination of whether a dividend qualifies as
an extraordinary dividend is subjective.
In contrast, Entity B enters into a VSF contract that entitles the counterparty to dividend benefits through a
reduction to the forward price related only to extraordinary dividends. In B’s case, extraordinary dividends are
defined as dividends in excess of 200 percent of the prevailing dividend rate as of the date on which B enters
into the contract. This VSF contract may be a participating security. In making this determination, B would be
required to evaluate the impact an extraordinary dividend would have on the original range. If the VSF contract
is considered a participating security, undistributed earnings should be allocated to the contract only if the
distribution of all undistributed earnings would constitute an extraordinary dividend.
Example 5-12
VSF Contract — Qualitative Evaluation to Determine Whether the Contract Is a Participating
Security
Entity X enters into a VSF contract that permits the counterparty to participate in increases in dividends on
X’s common stock if the contract is settled outside the final range. The term of the VSF contract is three years,
the low end of the original range equals the fair value of one share of X’s common stock at the inception of
the contract, the high end of the range equals 125 percent of the low end of the range, and X does not pay a
dividend or expect to pay one in the foreseeable future. Entity X’s common stock is not highly volatile. On the
basis of these facts, it is acceptable to conclude that it is at least reasonably possible that the VSF contract
ultimately will be settled within the range (i.e., the original range and final range are identical because a
dividend increase is not expected).
Note that, as discussed in Section 5.3.3.5.3.2, an entity must consider whether, at inception, it is at least
reasonably possible that a VSF contract will ultimately be settled within the final range. A final range whose
upper end is less than 110 percent of the lower end might contradict a conclusion that is reasonably possible
that the final stock price will be settled within the final range. A final range whose upper end is less than
120 percent of the lower end must be carefully considered.
Example 5-13
VSF Contract — Quantitative Evaluation to Determine Whether the Contract Is a Participating
Security
Entity Y enters into a VSF contract with the following terms:
- The counterparty must pay $100 to acquire Y’s common shares as of the settlement date, which is in one year.
- The number of common shares issued by Y depends on the fair value of Y’s common stock five days before the settlement date (the reference date) as follows:
- If the fair value of Y’s common shares on the reference date is below $100, Y issues one common share.
- If the fair value of Y’s common shares on the reference date is above $100 but below $120 (the original range, subject to adjustment), Y issues a number of common shares that have a fair value of $100.
- If the fair value of Y’s common shares on the reference date is $120 or more, Y issues 0.8333 common shares.
- The original range is $100 to $120, but this range is reduced if Y increases its normal dividends during the term of the VSF contract. For example, if Y increases its normal dividends by $4 during the term of the contract, the original range is reduced from $100–$120 to $100–$116. The settlement amount is determined on the basis of the final range, which is the original range plus any compression for dividend increases. The final range is adjusted for any standard antidilution events pertaining to Y’s common stock just as it is for dividends.
When Y enters into the VSF contract, it expects to increase dividends during the contract term, and it is possible
that such an increase could cumulatively reach $1.00 during the term of the contract. Entity Y has determined
that it should perform a quantitative analysis of the likelihood that the final range will be wide enough that it
is at least reasonably possible that the final common share price on the reference date will be within the final
range.
Entity Y devises two scenarios to gauge the sensitivity of the final range to
different increases in dividends: one scenario depicts
the effect of a $1.00 cumulative dividend increase; the
other scenario depicts the effect of a $4.00 cumulative
dividend increase. Using the formula contained in the
terms of the VSF contract, Y calculates the final ranges
for each scenario, as shown below.
Table 1 Illustration of Final Range With a $1 Increase in Dividends
Table 2 Illustration of Final Range With a $4 Increase in Dividends
On the basis of the following factors, Y concludes that it is reasonably possible that the VSF contract will be
settled within the final range:
- The final range is reduced by $1.00 for each $1.00 of increased dividends.
- It is unlikely that dividends would increase by more than $1.00 given Y’s expected performance, marketplace expectations, and the behavior of its competitors.
- The common stock is not highly volatile, and the term of the VSF contract is sufficiently short to support a conclusion that it is reasonably possible that the stock price will be within the indicated final range on the reference date.
Therefore, Y concludes that the VSF contract is not a participating security.
Footnotes
1
See Section 3.2.2 for additional
discussion of the nature and types of dividends on preferred stock
as well as the treatment of preferred stock dividends in the
calculation of income available to common stockholders.
2
An entity must also analyze the likelihood
that the contract will be settled inside or outside a range
of share prices to determine whether the instrument is a
liability under ASC 480-10-25-14. For more information, see
Section 6.2.4.4 of Deloitte’s Roadmap
Distinguishing Liabilities From
Equity.
3
Vested stock options would also be participating
securities if the holder is entitled to nonforfeitable dividends
during the period the option is outstanding.
5.4 Definition of Multiple Classes of Common Stock
5.4.1 General
ASC 260 only explicitly requires application of the two-class method when an
entity has multiple classes of common stock with different dividend rates and
the same level of subordination. Nevertheless, an entity should apply the
two-class method of calculating EPS when it has multiple classes of common
stock, regardless of whether (1) the dividend rates of each class are the same
or (2) one class has senior or prior rights. In comment letters, the staff in
the SEC’s Division of Corporation Finance has previously expressed its view that
ASC 260-10-45-60B(d) requires an entity with multiple classes of common stock to
present basic and diluted EPS for each class even if the classes have the same
dividend rates; thus, an entity should either (1) present basic and diluted EPS
for each class of common stock separately on the face of the income statement or
(2) present a single basic and diluted EPS on the face of the income statement
and clearly disclose that the EPS amounts pertain to each class of common stock.
An entity that chooses the latter option cannot simply assume that the amounts
of basic and diluted EPS for each class are the same. Rather, before reaching
such a conclusion, the entity must calculate basic and diluted EPS. It is
possible for EPS amounts to differ for multiple classes of common stock that
have the same dividend rates. For example, a participating security may only
participate in dividends ratably with one class of common stock, which could
have an impact on the calculation of basic EPS for that class of common stock.
(Section
5.5.3.2 discusses another situation in which a difference in
basic EPS may arise.) In addition, in the calculation of diluted EPS for
multiple classes of common stock, potential common shares are included on the
basis of the more dilutive of the two-class method or another relevant dilutive
method. As a result, there could be different amounts of diluted EPS for
multiple classes of common stock with the same dividend rates.
Section 3.1.1.1 discusses the determination of whether capital securities are treated as common
shares or preferred shares. While the treatment is generally based on the legal form of the security,
this is not always the case. If an entity has outstanding capital securities that are common stock in
legal form but have senior or prior rights over another class of common stock, the entity may treat the
outstanding securities as preferred securities in calculating EPS. In this circumstance, the outstanding
capital securities do not cause the entity to have multiple classes of common stock. However, the
two-class method of calculating EPS would still apply if the capital securities are participating securities.
The application of the two-class method of calculating EPS may differ depending on whether capital
securities are treated as a separate class of common stock or a participating security, because
participating securities generally do not participate in undistributed losses (see Section 5.5.2.2).
5.4.2 Redeemable Common Stock
When an entity has issued common stock that is redeemable at an amount other
than fair value and must be remeasured to its redemption amount under ASC
480-10-S99-3A, the security is treated in the same manner as a separate class of
stock in accordance with ASC 480-10-S99-3A(21). (See further discussion in
Section
5.5.3.1.) An NCI in the form of common stock that is redeemable at an
amount other than fair value and must be remeasured to its redemption amount
under ASC 480-10-S99-3A may also need to be treated as a separate class of stock
in the calculation of basic and diluted EPS at the subsidiary level.4 See further discussion in Section 5.5.2.5.4.
5.4.3 Tracking Stock
Some entities have issued classes of stock characterized as “tracking” or
“targeted” stock, which measure the performance of a specific business unit,
activity, or asset of the entity. Shares of tracking stock are traded as
separate securities although they typically do not have any specific claim on
the related assets and may have limited or no voting rights. According to ASC
260-10-45-60B, an entity with tracking stock must use the two-class method to
calculate and present EPS for each class of common stock. The two-class method
should be applied on the basis of the separate earnings attributed to each class
of stock, which represents the actual distributions, if any, to the respective
classes of stock and undistributed earnings available for payment of dividends
on these classes. An entity should show basic and diluted EPS for each class of
tracking stock on the face of the income statement. See Sections 3.2.4.3.3,
4.8.4.5, and
9.1.3 for
further discussion of EPS accounting matters applicable to tracking stock.
Footnotes
4
As noted in Section 8.8.1.1, the parent entity
must calculate basic and diluted EPS at the subsidiary level to
determine the amount of the subsidiary’s income that is included in the
numerator in the parent’s calculation of EPS.
5.5 Two-Class Method of Calculating EPS
5.5.1 General
ASC 260-10
Participating Securities and the Two-Class Method
45-60 The two-class method is
an earnings allocation formula that treats a
participating security as having rights to earnings that
otherwise would have been available to common
shareholders but does not require the presentation of
basic and diluted EPS for securities other than common
stock. The presentation of basic and diluted EPS for a
participating security other than common stock is not
precluded.
45-60A All securities that meet the definition of a participating security, irrespective of whether the securities
are convertible, nonconvertible, or potential common stock securities, shall be included in the computation of
basic EPS using the two-class method.
45-60B Under the two-class method:
- Income from continuing operations (or net income) shall be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends (or interest on participating income bonds) that must be paid for the current period (for example, unpaid cumulative dividends). Dividends declared in the current period do not include dividends declared in respect of prior-year unpaid cumulative dividends. Preferred dividends that are cumulative only if earned are deducted only to the extent that they are earned.
- The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to each security shall be determined by adding together the amount allocated for dividends and the amount allocated for a participation feature.
- The total earnings allocated to each security shall be divided by the number of outstanding shares of the security to which the earnings are allocated to determine the EPS for the security.
- Basic and diluted EPS data shall be presented for each class of common stock.
For the diluted EPS computation, outstanding common shares shall include all potential common shares
assumed issued. Example 6 (see paragraph 260-10-55-62) illustrates the two-class method.
45-65 Undistributed earnings for a period shall be allocated to a participating security based on the contractual
participation rights of the security to share in those current earnings as if all of the earnings for the period
had been distributed. If the terms of the participating security do not specify objectively determinable,
nondiscretionary participation rights, then undistributed earnings would not be allocated based on arbitrary
assumptions. For example, if an entity could avoid distribution of earnings to a participating security, even if all
of the earnings for the year were distributed, then no allocation of that period’s earnings to the participating
security would be made. Paragraphs 260-10-55-24 through 55-31 provide additional guidance on participating
securities and undistributed earnings.
45-66 Under the two-class method the remaining earnings shall be allocated to common stock and
participating securities to the extent that each security may share in earnings as if all of the earnings for the
period had been distributed. This allocation is required despite its pro forma nature and that it may not reflect
the economic probabilities of actual distributions to the participating security holders.
Participating Securities and Undistributed Earnings
55-25 If a participating security provides the holder with the ability to participate in all dividends declared with
the holders of common stock on a one-to-one per-share basis, then the undistributed earnings should be
allocated between the common stock and the participating security on a one-to-one per-share basis.
ASC 260 requires entities to apply the following two-step approach in allocating earnings under the
two-class method:
- Allocate distributed earnings to participating securities and common stock.
- Allocate undistributed earnings to participating securities and common stock.
The allocation of distributed earnings is based on the actual dividends or dividend equivalents, if
any, that were paid or payable during the period (and that pertain to the reporting period) to each
participating security and class of common stock. The amount of undistributed earnings that must be
allocated is equal to the numerator in the calculation of EPS less distributed earnings. Undistributed
earnings must be allocated to participating securities and classes of common stock on the basis of
their contractual entitlement to participate in distributions, under an assumption that all undistributed
earnings for the period were distributed. This hypothetical allocation is required regardless of whether
the entity intends to declare or pay dividends and even if there are contractual or legal restrictions on
the entity’s ability to pay dividends. The allocation of undistributed earnings to participating securities
and common shares should be based on the weighted-average participating securities and common
shares that were outstanding during a reporting period. It should not be based on the number of
participating securities or common shares outstanding as of the end of the reporting period. If an entity
can avoid a distribution of earnings to a participating security even if all earnings for the period were
distributed, the entity should not allocate undistributed earnings to that participating security.
The implementation guidance in ASC 260 on the two-class method of calculating EPS is written in the
context of basic EPS and does not explicitly address diluted EPS. However, the calculation of diluted
EPS under the two-class method is well established in practice and would be performed by using the
approach described in Section 5.5.4.
The remaining discussion in Section 5.5 provides guidance on using the two-class method to calculate
basic and diluted EPS. Section 5.5.5 provides examples illustrating the calculation of EPS under the
two-class method.
5.5.1.1 Quarterly and Year-to-Date Calculations
SEC Regulation S-X requires SEC registrants to present EPS in their quarterly reports on Form 10-Q.
Other entities that are required, or that elect, to present EPS may also issue financial statements on an
interim basis (e.g., quarterly or semiannually). When issuing interim-period financial statements, entities
include basic and diluted EPS for both the interim period and the year-to-date period.
For year-to-date calculations, an entity should allocate undistributed earnings to participating securities
and classes of common stock on a discrete, or independent, basis as if all undistributed earnings for
the entire year-to-date period were distributed. That is, the allocation is made without regard to how
the undistributed earnings were allocated for the interim financial reporting periods that are part
of the year-to-date financial reporting period. This approach is consistent with the guidance in ASC
260-10-55-3 through 55-3B, as discussed in Section 4.9, which requires that year-to-date diluted EPS be
calculated on the basis of the numerator for the year-to-date period.
The allocation of undistributed earnings in interim-period calculations of EPS (e.g., an EPS calculation for
a quarterly financial reporting period) is generally not controversial when the entitlement of common
shares and participating securities to share in earnings according to their contractual participation terms
is based on discrete interim periods. However, when the contractual participation terms related to
the rights to participate in distributions are based on distributions made over an entire annual period,
additional considerations are necessary regarding the calculations of EPS under the two-class method
for interim periods after the first interim period.
On the basis of informal discussions with the FASB staff during the deliberations of EITF Issue 07-4, there are two views in practice on the
allocation of undistributed earnings to interim periods, since the guidance
in ASC 260 on the two-class method is unclear on this matter. Specifically,
ASC 260-10-45-60B(b) states that undistributed earnings “shall be allocated
to common stock and participating securities to the extent that each
security may share in earnings as if all of the earnings
for the period had been distributed” (emphasis added). The two views
are related to the meaning of the phrase “all of the earnings for the
period” as follows (note that these two views are acceptable only when an
entity pays distributions by using a complex allocation formula on the basis
of an annual distribution):
-
View A: Discrete-period basis — Some interpret “all of the earnings for the period” as indicating that an allocation is required in an interim period on a discrete, or independent, basis as if all undistributed earnings for the interim period were allocated without regard to any allocations made in prior interim periods. In other words, each interim period would be treated in the same manner as an annual period is treated in a year-to-date calculation of EPS. Proponents of View A believe that this approach is required because it is consistent with the period-by-period approach that is generally prescribed by ASC 260. Under this approach, the undistributed earnings allocated to each participating security and class of common stock on a year-to-date basis will often not equal the sum of the interim-period undistributed earnings allocated to each participating security and class of common stock. This same phenomenon exists for calculations of diluted EPS when the two-class method does not apply.
-
View B: Cumulative-period basis — Others interpret “all of the earnings for the period” as not addressing how to allocate undistributed earnings to interim periods. Proponents of View B believe that each interim period is an integral part of a year-to-date period. They further believe that in interim periods after the first interim period, the prior interim-period allocations of undistributed earnings must be considered when distribution formulas are contractually based on earnings during an annual period so that the allocation of undistributed earnings is appropriately reflected in accordance with the “contractual participation rights” of each security under ASC 260-10-45-65. Under this approach, the undistributed earnings allocated to each participating security and class of common stock on a year-to-date basis will often equal the sum of the interim-period undistributed earnings allocated to each participating security and class of common stock; however, the two amounts may not be equal if the distribution formulas are complex or there are undistributed losses during a financial reporting period (i.e., as illustrated in Example 5-15, undistributed losses during a particular financial reporting period should not be allocated to securities that do not absorb losses).
Either of these two approaches is acceptable provided that it is applied
consistently as an accounting policy and disclosed, if material. Regardless
of the method chosen, the denominator in the calculation of diluted EPS will
continue to be subject to the guidance applicable to each method of
computing diluted EPS on an interim and year-to-date basis, as discussed in
Chapter 4.
Example 5-14
illustrates the application of these two alternative views.
5.5.1.1.1 Distribution Formulas That Include a Return of Originally Invested Capital
The allocation of cash distributions by some entities is contractually based on a distribution formula
(i.e., a “waterfall” formula) in which common shares or participating securities must first receive a return
of their initial invested capital before any distributions can be made on other securities. For example,
an entity may have three classes of participating preferred stock outstanding (i.e., Series A, Series B,
Series C) and common shares. The entity’s articles of incorporation, bylaws, or other organization
documents may specify that distributions must first be made to repay the remaining unreturned capital
contribution on Series A before any distributions can be made on Series B, Series C, and common stock.
Once the unreturned capital contributions have been distributed on Series A, distributions must be paid
to return the Series B unreturned capital contribution before distributions can be paid on Series C and common stock. Once Series C has received its unreturned capital contribution, distributions are paid on
Series A, Series B, Series C, and common stock according to a specified formula.
In these types of allocation formulas, regardless of the method applied in
Section
5.5.1.1 for interim-period calculations of EPS under the
two-class method, an entity should allocate undistributed earnings,
taking into consideration the unreturned capital contributions of each
security as of the beginning of the interim period. The two-class method
of calculating EPS is an allocation of earnings and therefore should be
applied on the basis of the return on capital rather than the
return of capital. For further discussion of the allocation of
undistributed earnings by an MLP, see Section 8.9.3.
5.5.2 Application of Two-Class Method to Participating Securities
5.5.2.1 Liability-Classified Participating Securities
An entity may have outstanding participating securities that are classified as liabilities for accounting
purposes. Liability-classified participating securities may be recognized in the statement of financial
position at fair value, with periodic changes in fair value recognized in earnings (or other comprehensive
income for the portion related to the change in the issuing entity’s own credit risk). Alternatively, such
securities may be recognized in the statement of financial position by using another measurement
attribute under other relevant GAAP, such as intrinsic value, current settlement value, or amortized
cost. The classification of securities as liabilities, and their subsequent-measurement attribute, has no
impact on whether they are participating securities to which an entity must apply the two-class method
of calculating EPS.
5.5.2.1.1 Distributed Earnings for Liability-Classified Participating Securities
Dividends declared on liability-classified participating securities that have
been recognized in the income statement as an expense (e.g., interest
expense, compensation expense, other income or expense) should not also
be treated as a reduction of income available to common stockholders to
arrive at undistributed earnings. The recognition of these dividends a
second time through the allocation of distributed earnings would result
in “double counting” the impact of these dividends. An entity should
count dividends declared once, but not twice, in calculating EPS under
the two-class method. See Example 5-19 for an illustration
of this concept.
5.5.2.1.2 Undistributed Earnings for Liability-Classified Participating Securities
The periodic change in the carrying amount of a liability-classified participating security (e.g., change
in fair value, change in intrinsic value, change in current settlement value, interest, dividends
on share-based payment awards not expected to vest) that is recognized in the income statement will
affect net income and therefore the amount of undistributed earnings (losses). Under the two-class
method of calculating EPS, an entity may not reverse such amounts from undistributed earnings or
losses. However, in calculating diluted EPS, an entity may be required to adjust the numerator to reverse
the income statement effect on certain potential common shares that are more dilutive under the
treasury stock, if-converted, or contingently issuable share method than under the two-class method of
calculating diluted EPS. Only in these circumstances is it appropriate to adjust undistributed earnings
for the earnings effect that resulted from classifying the instrument as a liability. See Section 5.5.4 for
further discussion of the two-class method of calculating diluted EPS.
5.5.2.2 Allocation of Undistributed Losses to Participating Securities
ASC 260-10
Participating Securities and the Two-Class Method
45-67 An entity would allocate losses to a nonconvertible participating security in periods of net loss if, based
on the contractual terms of the participating security, the security had not only the right to participate in the
earnings of the issuer, but also a contractual obligation to share in the losses of the issuing entity on a basis
that was objectively determinable. Determination of whether a participating security holder has an obligation to
share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based on
the contractual rights and obligations of the participating security. The holder of a participating security would
have a contractual obligation to share in the losses of the issuing entity if either of the following conditions is
present:
- The holder is obligated to fund the losses of the issuing entity (that is, the holder is obligated to transfer assets to the issuer in excess of the holder’s initial investment in the participating security without any corresponding increase in the holder’s investment interest).
- The contractual principal or mandatory redemption amount of the participating security is reduced as a result of losses incurred by the issuing entity.
45-68 A convertible participating security should be included in the computation of basic EPS in periods of
net loss if, based on its contractual terms, the convertible participating security has the contractual obligation
to share in the losses of the issuing entity on a basis that is objectively determinable. The guidance in this
paragraph also applies to the inclusion of convertible participating securities in basic EPS, irrespective of the
differences that may exist between convertible and nonconvertible securities. That is, an entity should not
automatically exclude a convertible participating security from the computation of basic EPS if an entity has a
net loss from continuing operations. Determination of whether a participating security holder has an obligation
to share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based
on the contractual rights and obligations of the participating security.
An entity will have undistributed losses, as opposed to undistributed earnings, during a financial
reporting period in the following situations:
- The entity has a loss attributable to common stockholders.
- The entity has distributed more cash in the form of dividends or dividend equivalents than earnings for the period (i.e., cash distributions exceed income available to common stockholders).
Like undistributed earnings, undistributed losses must be allocated under the
two-class method of calculating EPS. When an entity has undistributed losses
and allocates a portion of those losses to a participating security, net
loss per common share will be reduced. Therefore, it is important to
determine whether participating securities share in undistributed losses
with common shareholders. If a participating security does not share in
losses, undistributed losses should be allocated only to the entity’s common stock.5 If an entity has multiple classes of common stock, undistributed
losses should be allocated to the classes of common stock in accordance with
their terms, which must take into account whether the classes of common
stock share equally in earnings or distributions on liquidation. See further
discussion in Section
5.5.3.3.
Connecting the Dots
It may seem intuitive to think that when undistributed losses are allocated solely to common
shares, there is no need to calculate diluted EPS under the two-class method. However, that
is not necessarily true. The control number for diluted EPS under the two-class method could
be income, notwithstanding cash distributions in excess of the control number for basic EPS, because (1) an entity must recalculate and reallocate undistributed earnings to apply the
two-class method when potential common shares are also participating securities and (2) the
entity may adjust the numerator in the calculation of diluted EPS if it has contracts that may be
settled in cash or common stock. See Section 5.5.4 for further discussion of the calculation of
diluted EPS under the two-class method.
Undistributed losses are allocated to a participating security only if the security contains a
nondiscretionary and objectively determinable contractual obligation to share in net losses.
Just because a security participates in earnings on a nondiscretionary and objectively determinable
basis does not mean it participates in losses. In fact, most participating securities do not share in losses.
A participating security only has a contractual obligation to participate in losses in the following two
circumstances:
- The counterparty is required to fund the losses of the entity (i.e., to “write a check” to the entity).
- The contractual principal or mandatory redemption amount of the participating security is reduced as a result of losses incurred by the entity.
Although the guidance in ASC 260-10-45-67 and 45-68 was written in the context of participating debt
or preferred stock instruments, it should be applied to all types of participating securities. An entity
must consider the contractual rights and obligations of the participating security in assessing whether
a security holder is obligated to share in the entity’s net losses on a period-by-period basis. It is unusual
for participating securities to have a contractual obligation to share in undistributed losses on an
objectively determinable and nondiscretionary basis. If the contractual terms of the participating security
do not specifically require the security holder to participate in losses or do not address the manner of
such loss participation, the entity should not allocate undistributed losses to the participating security.
Connecting the Dots
Because ASC 260-10-45-67 and 45-68 were only written to address participating debt or
preferred stock instruments, questions have arisen regarding whether a nonvested stock
award that is a participating security because the holder is entitled to nonforfeitable dividends
participates in losses. Undistributed losses (whether resulting from a net loss for a period or
distributed earnings that exceed income available to common stockholders) are generally not
allocated to share-based payment awards that meet the definition of a participating security
because the awards do not contain specific language that creates a contractual obligation
for the employee to absorb losses. The forfeiture provisions of the awards do not affect this
evaluation. However, once a nonvested share-based payment award vests and becomes an
outstanding share of common stock, it would participate in losses (see discussion of common
shares in Section 5.5.3.3). Therefore, when an entity has undistributed losses and nonvested
shares vest during a financial reporting period, the entity must allocate the undistributed losses
to the share-based payment arrangement for the portion of the period in which the award
was a vested common share. This allocation is generally performed on the basis of a weighted
average.
5.5.2.2.1 Allocation of Undistributed Losses to Participating Securities When an Entity Reports a Discontinued Operation
ASC 260 does not address how an entity should apply the two-class method when it reports a
discontinued operation. Entities will therefore need to consider how to allocate earnings (losses) under
the two-class method of calculating EPS, which must be done for continuing operations, discontinued
operations, and overall net income (loss) when an entity has participating securities or multiple classes
of common stock.
5.5.2.2.1.1 Distributed Earnings (Losses)
In a manner consistent with the typical application of the two-class method of
calculating EPS, any declared dividends reduce (increase) overall
net income (net loss) to arrive at undistributed earnings (losses).
Typically, distributed earnings will be considered as reducing
income (increasing losses) from continuing operations. However, if
the discontinued operation arises from a spin-off of a subsidiary
that has issued participating securities in the subsidiary, an
allocation of distributed earnings between continuing operations and
discontinued operations would be required.
5.5.2.2.1.2 Undistributed Earnings (Losses)
As discussed in Section 5.5.2.2, ASC 260 specifies that an entity should not allocate undistributed
losses to a participating security if, according to its contractual terms, the participating security does not
have a contractual obligation to absorb such losses on a basis that is nondiscretionary and objectively
determinable. In practice, it is uncommon for a participating security, including an unvested share-based
payment award, to participate in undistributed losses. If an entity reports income from continuing
operations but an overall net loss (because of losses from discontinued operations) or reports a loss
from continuing operations but overall net income (because of income from discontinued operations),
the entity must determine which measure is used to allocate income to participating securities when it
allocates income, but not losses, to participating securities.
If an entity has outstanding securities that participate in income, but not
losses, and those securities participate with common shareholders in
the entity’s overall net income, the entity should use overall net
income (loss) to allocate undistributed earnings (losses). That is,
these participating securities participate in all of the entity’s
undistributed earnings and none of its undistributed losses. The
table below illustrates the allocation of undistributed earnings
(losses) when an entity has participating securities that
participate in its overall net income but do not absorb
undistributed losses.
Table 5-3
Entity Reports6 | Continuing
Operations | Discontinued
Operations | Overall | Allocation to Participating Security |
---|---|---|---|---|
Scenario 1 | Income | Income | Income | The entity should allocate undistributed earnings
from continuing operations to the participating
security and should allocate undistributed earnings
from discontinued operations to the participating
security. The total amount of undistributed
earnings allocated to the participating security
from continuing and discontinued operations
should equal the overall undistributed earnings
allocated to the participating security. |
Scenario 2 | Income | Loss | Income | The entity should allocate undistributed earnings
from continuing operations to the participating
security and should allocate undistributed losses
from discontinued operations to the participating
security. The net amount of undistributed earnings
allocated to the participating security from
continuing and discontinued operations should
equal the overall undistributed earnings allocated
to the participating security. |
Scenario 3 | Income | Loss | Loss | No allocations are made to the participating
security because the entity reported an overall
loss and the participating security does not absorb
losses. |
Scenario 4 | Loss | Loss | Loss | No allocations are made to the participating
security because the entity reported an overall
loss and the participating security does not absorb
losses. |
Scenario 5 | Loss | Income | Loss | No allocations are made to the participating
security because the entity reported an overall
loss and the participating security does not absorb
losses. |
Scenario 6 | Loss | Income | Income | The entity should allocate undistributed losses
from continuing operations to the participating
security and should allocate undistributed earnings
from discontinued operations to the participating
security. The net amount of undistributed earnings
allocated to the participating security from
continuing and discontinued operations should
equal the overall undistributed earnings allocated
to the participating security. |
Connecting the Dots
As discussed in Section
4.1.2.2, the control number in the
determination of whether potential common shares are
dilutive is income from continuing operations. However, this
control number concept is not relevant to the allocation of
undistributed earnings (losses) to participating securities
in the scenarios above because the participating securities
participate in the overall performance of the entity. Thus,
solely with respect to allocating undistributed earnings
(losses) to participating securities under the two-class
method, the control number is overall net income (loss)
(i.e., total undistributed earnings [losses] for the
period).
In terms of calculating diluted EPS under the two-class method, which is
discussed in Section 5.5.4, the
treasury stock, reverse treasury stock, if-converted, or
contingently issuable share method would not be applied to
calculate diluted EPS in scenarios 4–6, because those
methods would be antidilutive since the control number in
the calculation of diluted EPS is income from continuing
operations, which is a loss in these scenarios. However, for
scenarios 1–3, since the control number is income, those
methods of calculating diluted EPS would be applied in
accordance with the antidilution sequencing requirements, as
discussed in Section 4.1.2.3.
If an entity has securities that participate with common shareholders in earnings, but not losses, and
those securities participate only in the earnings of a specific subsidiary or business operation of the
entity, the entity must consider the facts and circumstances related to the terms of the participating
securities to determine the proper allocation of undistributed earnings (losses) to continuing operations,
discontinued operations, and overall net income (loss) for the period. If securities participate only in
earnings of a specific subsidiary or business operation and that subsidiary or operation is contained
only within continuing operations or only within discontinued operations, the entity should base
its allocation of undistributed earnings only on the undistributed earnings (if any) from continuing
operations or discontinued operations, respectively. In all situations, the entity must ensure that the overall net amount allocated to a participating security (i.e., the aggregate of the allocations from
continuing and discontinued operations) reflects the net amount of undistributed earnings that would
be allocable to the participating security if all undistributed earnings in which the security is entitled to
participate had been distributed for the period.
5.5.2.3 Participating Securities Issued or Redeemed During an Interim Reporting Period
SEC Regulation S-X requires SEC registrants to present EPS in their quarterly reports on Form 10-Q.
Accordingly, if an entity has participating securities outstanding during a quarterly financial reporting
period, it is required to prepare EPS under the two-class method for those interim financial reporting
periods.
An entity may issue or redeem a participating security during a quarterly financial reporting period. A
counterparty may also convert a participating security into common stock during a quarterly financial
reporting period. There are two acceptable methods of incorporating the impact of the issuance,
redemption, or conversion of a participating security during a quarterly financial reporting period in
a quarterly calculation of EPS under the two-class method in accordance with ASC 260: the discrete
method and the weighted-average method. An entity’s choice of either method represents an
accounting policy that must be consistently applied and disclosed, if material.
5.5.2.3.1 Discrete Method
Under the discrete method, the entity prepares, during the single financial reporting period, two EPS
calculations for both basic and diluted EPS, one for the portion of the financial reporting period for
which the participating security was outstanding and the other for the portion of the financial reporting
period for which the participating security was not outstanding. The date of separation for the two
separate calculations is the date of the participating security’s issuance, redemption, or conversion. The
entity aggregates the two separate calculations to determine the reported amounts of basic and diluted
EPS for the entire quarterly financial reporting period.
The appropriateness of the discrete method depends on the entity’s performance of two financial
reporting closings during a single quarterly financial reporting period, with each closing reflecting the
same processes and internal controls normally applied to a quarter-end closing. Given the complexity
of this approach, which requires an entity to (1) allocate net income to the discrete portions of the
quarterly financial reporting period and (2) calculate accruals and estimates twice during a single
quarterly financial reporting period, entities will most likely choose to apply the weighted-average
method.
5.5.2.3.2 Weighted-Average Method
The weighted-average method is predicated on the general requirement in ASC 260 to determine
outstanding common shares and potential dilutive common shares on a weighted-average basis. The
two-class method is applied under this approach, as discussed below.
5.5.2.3.2.1 Numerator
Net income attributable to common stockholders is first reduced by dividends declared during the
quarterly reporting period, with the remaining amount representing undistributed earnings. The
amount of dividends, if any, paid on the participating securities issued, redeemed, or converted during
the period will represent the actual amount of dividends declared or paid on such securities during
the quarterly financial reporting period (i.e., the distributed earnings). Undistributed earnings will be allocated to common shares and the participating securities issued, redeemed, or converted during the
quarterly financial reporting period on the basis of the weighted-average number of common shares
and participating securities outstanding during the quarterly financial reporting period. An allocation
based on the weighted-average number of common shares and participating securities outstanding
during the quarterly financial reporting period (in lieu of an allocation based on the period-end number
of outstanding shares of common stock and participating securities) of undistributed earnings under
the two-class method is consistent with other guidance in ASC 260 (see ASC 260-10-45-26 and ASC
260-10-45-42, which address the treatment of options or convertible debt issued, canceled, exercised,
or converted during a reporting period). In addition, such allocation reflects the notion that income
is earned and distributed evenly throughout the financial reporting period and is not a one-time
distribution of earnings as of the end of the financial reporting period.
5.5.2.3.2.2 Denominator
In a manner similar to the treatment of the numerator, the number of outstanding common shares used
in an entity’s calculation of basic and diluted EPS should be based on the weighted-average number of
shares of common stock outstanding during the quarterly financial reporting period, as required by ASC
260-10-45-10.
ASC 260 does not require presentation or disclosure of basic or diluted EPS for a participating security
that is not a class of common stock. However, if an entity presents or discloses such EPS amounts, the
denominator in the EPS calculation should be the weighted-average number of securities outstanding
only for the period during the quarterly financial reporting period in which the class of participating
securities was outstanding. For example, if a class of participating securities was entirely redeemed or
settled on the 46th day of the quarterly financial reporting period, the weighted-average calculation of
the number of securities outstanding should be based on a 45-day period.
5.5.2.4 Participation Is Contingent on a Specified Event
ASC 260-10
Participating Securities and Undistributed Earnings
55-26 If a participating security provides the holder with the ability to participate with the holders of common
stock in dividends declared contingent upon the occurrence of a specified event, the occurrence of which is
subject to management discretion or is not objectively determinable (for example, liquidation of the entity or
management determination of an extraordinary dividend), then the terms of the participating security do not
specify objectively determinable, nondiscretionary participation rights; therefore, undistributed earnings would
not be allocated to the participating security.
55-27 If a participating security provides the holder with the ability to participate with the holders of common
stock in earnings for a period in which a specified event occurs, regardless of whether a dividend is paid during
the period (for example, achievement of a target market price of a security or achievement of a certain earnings
level), then undistributed earnings would be allocated to common stock and the participating security based
on the assumption that all of the earnings for the period are distributed. Undistributed earnings would be
allocated to the participating security if the contingent condition would have been satisfied at the reporting
date, irrespective of whether an actual distribution was made for the period.
55-28 If a participating security provides the holder with the ability to participate in extraordinary dividends
and the classification of dividends as extraordinary is predetermined by a formula, for example, any dividend
per common share in excess of 5 percent of the current market price of the stock is defined as extraordinary,
then undistributed earnings would be allocated to common stock and the participating security based on the
assumption that all of the earnings for the period are distributed. If earnings for a given period exceed the
specified threshold above which the participating security would participate (that is, earnings for the period are
in excess of 5 percent of the current market price of the stock), undistributed earnings would be allocated to
the participating security according to its terms.
55-29 If a participating security provides the holder with the ability to participate in extraordinary dividends
and the classification of dividends as extraordinary is within the sole discretion of the board of directors,
then undistributed earnings would be allocated only to common stock. Since the classification of dividends
as extraordinary is within the sole discretion of the board of directors, undistributed earnings would not be
allocated to the participating security as the participation in the undistributed earnings would not be objectively
determinable.
55-30 If a participating security provides the holder with the ability to participate in all dividends up to a
specified threshold (for example, the security participates in dividends per common share up to 5 percent of
the current market price of the stock), then undistributed earnings would be allocated to common stock and
the participating security based on the assumption that all of the earnings for the period are distributed. In this
example, undistributed earnings would be allocated to common stock and to the participating security up to
5 percent of the current market price of the common stock, as the amount of the threshold for participation
by the participating security is objectively determinable. The remaining undistributed earnings for the period
would be allocated to common stock.
55-31 See Example 9 (paragraph 260-10-55-71) for an illustration of this guidance.
As noted in ASC 260-10-55-27, the two-class method applies when a security participates in
earnings only upon the occurrence of a specified contingent event, provided that such participation
is objectively determinable and nondiscretionary. While various types of contingencies may affect
participation, examples include securities that participate (1) on the basis of the entity’s earnings or
other performance measures or the entity’s common stock price or (2) upon discrete events such as
the occurrence of an IPO or business combination. If participation is based on conditions that are not
objectively determinable or that are at the entity’s discretion if the contingency occurs, allocation of
undistributed earnings to the security under the two-class method is precluded. Participation may be
considered not objectively determinable if it depends on a condition that is subject to interpretation (i.e.,
it is subjective rather than objective).
Undistributed earnings should be allocated to a participating security that
participates contingently only if the condition on which participation is
based is satisfied as of the reporting date.7 Thus, for each financial reporting period, an entity must evaluate
whether the relevant condition has been met as of the reporting date under
an assumption that all undistributed earnings for the period are
distributed.8 If the relevant condition is met, the entity should allocate earnings
to the participating security on the basis of an assumption that all
earnings for the period were distributed (regardless of whether an actual
distribution was made for the period). This reporting-date approach is
consistent with the approach to diluted EPS approach for contingently
issuable shares, which is discussed in Section 4.5. Because the condition may
be met as of some reporting-period dates and not others, such securities may
participate in undistributed earnings in some quarterly financial reporting
periods but not in others. Example
5-18 illustrates this concept.
5.5.2.5 Application to Specific Types of Participating Securities
5.5.2.5.1 Participating Preferred Stock
An entity should apply the two-class method to preferred stock only if the preferred stock meets the
definition of a participating security. See Section 5.3.3.2 and Examples 5-2, 5-3, and 5-4 for discussion of
whether preferred stock meets the definition of a participating security.
As discussed in ASC 260-10-45-60, the two-class method is “an earnings allocation formula that treats a
participating security as having rights to earnings that otherwise would have been available to common
shareholders.” In accordance with ASC 260, an entity that has participating preferred stock should
allocate distributed and undistributed earnings in calculating basic EPS under the two-class method as
follows:
- Distributed earnings — Distributed earnings allocable to participating preferred stock include (1) the amount of dividends declared in the current period on the preferred stock; (2) the amount of any unpaid cumulative dividends on the preferred stock for the current period; and (3) the amount of any other current-period “deemed dividends” or “deemed contributions” on the preferred stock.9 In summary, distributed earnings equal the dividends on the preferred stock that reduce net income in arriving at income available to common stockholders during the financial reporting period. Distributed earnings on cumulative preferred stock would not include the payment of dividends that have accumulated in a prior financial reporting period, since those accumulated dividends would have been considered distributed earnings in that prior financial reporting period.Distributed earnings on common stock and other participating securities are based on the amount of dividends declared during the current period. If an entity is required to reduce income available to common stockholders to reflect a down-round feature, as discussed in Section 3.2.5.3, that amount would also be treated as distributed earnings.
- Undistributed earnings — To arrive at undistributed earnings, an entity adjusts both income (loss) from continuing operations and net income (loss) (or income [loss] from continuing operations attributable to common stockholders of the parent and net income [loss] attributable to common stockholders of the parent if the entity had an NCI) by the amount of distributed earnings to arrive at undistributed earnings or losses. Undistributed earnings or undistributed losses are allocated to common stock and participating securities, including participating preferred stock, to the extent that each security may share in such earnings or absorb such losses (as determined on the basis of the contractual participation rights of each participating security) under an assumption that all of the undistributed earnings or losses for the period were distributed.
The total earnings or losses allocated to each security (i.e., the sum of distributed earnings and
undistributed earnings or losses) are divided by the number of the security’s outstanding units to
calculate basic EPS for the security. Diluted EPS is calculated under the two-class method, as discussed
in Section 5.5.4. ASC 260-10-45-60 indicates that entities are permitted, but not required, to present
basic and diluted EPS for a participating preferred security. See further discussion in Section 9.1.4.
For illustrations of how the two-class method is applied by an entity whose
capital structure includes preferred stock that meets the definition of
a participating security, see Examples 5-16, 5-20, 5-21, and
5-22.
Table 5-4 summarizes various scenarios
related to preferred stock. The table also summarizes scenarios
illustrating whether and, if so, how an entity with a capital structure
that includes preferred stock should apply the two-class method of
calculating EPS, depending on whether (1) dividends on the preferred
stock are cumulative or noncumulative and (2) the preferred stock is a
participating security. In the scenarios, it is assumed that:
-
The entity’s capital structure includes only a single class of common stock and a single class of preferred stock that were not issued in a share-based payment arrangement.
-
The entity did not declare or pay any dividends on common stock during the period. (If the entity had declared dividends on common stock, those dividends would be included in the distributed earnings under the two-class method.)
-
The preferred stock does not represent a redeemable equity security for which periodic measurement adjustments are required under ASC 480-10-S99-3A. (If the entity’s preferred stock had been remeasured to its redemption amount under ASC 480-10-S99-3A, those measurement adjustments would be reflected as dividends or distributed earnings on the preferred stock.)
-
The preferred stock does not contain a contractual obligation to share in losses. (If the preferred stock had a contractual obligation to absorb losses, which would be unusual, any undistributed losses would be allocated to the preferred stock.)
Table 5-4
Dividends on
Preferred Stock | Preferred Stock Meets the Definition of
Participating Security | Preferred Stock Does Not Meet the
Definition of Participating Security |
---|---|---|
Cumulative (Regardless of Whether Declared or Paid) | ||
The entity
reports net
income for the
period that is
greater than
the cumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the cumulative dividends on preferred stock
for the period. The remaining undistributed
earnings for the period should be allocated
to the common stock and preferred stock
on the basis of the contractual participation
rights of each security as if all earnings for
the period were distributed. | The two-class method does not apply.
The entity should compute income available
to common stockholders (the numerator in
the calculation of basic EPS) by deducting
from net income the dividends on the
preferred stock that accumulated during the
period. |
The entity
reports net
income for the
period that is
less than the
cumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the cumulative dividends on preferred stock
for the period. The resulting undistributed
losses for the period should be allocated
entirely to the common stock. No
undistributed losses should be allocated to
the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by deducting from
net income the dividends on the preferred
stock that accumulated during the period. |
The entity
reports net loss
for the period. | The two-class method applies.
Distributed earnings for the period equal
the cumulative dividends on preferred stock
for the period. The resulting undistributed
losses for the period should be allocated
entirely to the common stock. No
undistributed losses should be allocated to
the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by adding to net
loss the dividends on the preferred stock
that accumulated during the period. |
Noncumulative (and Declared for the Period) | ||
The entity
reports net
income for the
period that is
greater than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the noncumulative dividends declared
on preferred stock for the period. The
remaining undistributed earnings for the
period should be allocated to the common
stock and preferred stock on the basis of
the contractual participation rights of each
security as if all earnings for the period were
distributed. | The two-class method does not apply.
The entity should compute income available
to common stockholders (the numerator in
the calculation of basic EPS) by deducting
from net income the dividends on the
preferred stock that were declared during
the period. |
The entity
reports net
income for the
period that is
less than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the noncumulative dividends declared on
preferred stock for the period. The resulting
undistributed losses for the period would be
allocated entirely to the common stock. No
undistributed losses should be allocated to
the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by deducting from
net income the dividends on the preferred
stock that were declared during the period. |
The entity
reports net loss
for the period. | The two-class method applies.
Distributed earnings for the period equal
the noncumulative dividends declared on
preferred stock for the period. The resulting
undistributed losses for the period should
be allocated entirely to the common stock.
No undistributed losses should be allocated
to the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by adding to net
loss the dividends on the preferred stock
that were declared during the period. |
Noncumulative (and Not Declared or Paid for the Period) | ||
The entity
reports net
income for the
period that is
greater than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
There are no distributed earnings for the
period. Undistributed earnings for the
period should first be allocated to the
preferred stock in an amount equal to the
noncumulative dividends on preferred stock
for the period. The remaining undistributed
earnings for the period should be allocated
to the common stock and preferred stock
on the basis of the contractual participation
rights of each security as if all earnings for
the period were distributed. | The two-class method does not apply.
There should be no adjustments to net
income. Net income for the period should
represent the numerator in the calculation
of basic EPS. |
The entity
reports net
income for the
period that is
less than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
There are no distributed earnings for the
period. Undistributed earnings for the
period (equal to net income for the period)
should be allocated entirely to the preferred
stock. No income or loss should be allocated
to the common stock. | The two-class method does not apply.
There should be no adjustments to net
income. Net income for the period should
represent the numerator in the calculation
of basic EPS. |
The entity
reports net loss
for the period. | The two-class method applies.
There are no distributed earnings for the
period. Undistributed losses (equal to net
loss for the period) should be allocated
entirely to the common stock. No income or
losses should be allocated to the preferred
stock because the preferred stock does not
contain a contractual obligation to absorb
losses. | The two-class method does not apply.
There should be no adjustments to net loss.
Net loss for the period should represent the
numerator in the calculation of basic EPS. |
See Section 5.5.2.5.3A for discussion of
application of the two-class method of calculating EPS to mandatorily
convertible preferred stock arrangements that contain a variable number
of common shares issuable upon settlement.
5.5.2.5.2 Participating Share-Based Payment Awards
ASC 260-10
Participating Securities and the Two-Class Method
45-68B Paragraph 718-10-55-45 requires that nonrefundable dividends or dividend equivalents paid on
awards for which the requisite service is not (or is not expected to be) rendered be recognized as additional
compensation cost and that dividends or dividend equivalents paid on awards for which the requisite service
is (or is expected to be) rendered be charged to retained earnings. As a result, an entity shall not include
dividends or dividend equivalents that are accounted for as compensation cost in the earnings allocation
in computing EPS. To do so would include the dividend as a reduction of earnings available to common
shareholders from both compensation cost and distributed earnings. Undistributed earnings shall be allocated
to all share-based payment awards outstanding during the period, including those for which the requisite
service is not expected to be rendered (or is not rendered because of forfeiture during the period, if an entity
elects to account for forfeitures when they occur in accordance with paragraph 718-10-35-3). An entity’s
estimate of the number of awards for which the requisite service is not expected to be rendered (or no
estimate, if the entity has elected to account for forfeitures when they occur in accordance with paragraph
718-10-35-3) for the purpose of determining EPS under this Topic shall be consistent with the estimate used
for the purposes of recognizing compensation cost under Topic 718. Paragraph 718-10-35-3 requires that an
entity apply a change in the estimate of the number of awards for which the requisite service is not expected
to be rendered in the period that the change in estimate occurs. This change in estimate will affect net income
in the current period; however, a current-period change in an entity’s expected forfeiture rate would not affect
prior-period EPS calculations. See Example 9 for an illustration of this guidance.
In addressing share-based payment awards granted to employees, ASC 718-10-35-3
states, in part, that “[t]he total amount of compensation cost
recognized at the end of the requisite service period for an award of
share-based compensation shall be based on the number of instruments for
which the requisite service has been rendered (that is, for which the
requisite service period has been completed).” Regarding the
determination of the amount of compensation cost to recognize in each
reporting period, ASC 718-10-35-3 allows entities to elect, as an
entity-wide accounting policy, to either (1) estimate forfeitures before
they occur (i.e., recognize compensation cost on the basis of the number
of share-based payment awards that are expected to vest) or (2)
recognize the effect on compensation cost of awards for which the
requisite service period is not rendered only when the award is
forfeited. The guidance in ASC 718-10-35-3 applies to all share-based
payment awards, regardless of their classification as an equity or
liability instrument.10
The accounting policy elected regarding the treatment of forfeitures will affect
how the entity treats dividends in applying the two-class method when it
has granted share-based payment awards that are participating securities
because they contain nonforfeitable rights to dividends before vesting.
The discussion below pertains to participating share-based payment
awards granted to employees that are classified as equity
instruments.11
-
Entity estimates forfeitures — Distributed earnings during a period will equal the current-period dividends on unvested participating share-based payment awards that are expected to vest (i.e., the amount of dividends on unvested participating share-based payment awards that have been charged to retained earnings during the period). Dividends on awards that are not expected to vest and that have been recognized as compensation expense are not considered distributed earnings under the two-class method since doing so would result in the “double counting” of such dividends. An entity should allocate undistributed earnings to all unvested participating share-based payment awards outstanding during the period on the basis of the weighted-average number of awards outstanding during the period. Undistributed losses are generally not allocated to share-based payment awards, as discussed in Section 5.5.2.2.
-
Change in estimated forfeitures — In accordance with ASC 718-10-35-3, in the period of a change in estimated forfeitures, an entity is required to adjust compensation cost to reflect the cumulative effect on current and prior periods of the change in the estimated number of instruments for which the requisite service period is expected to be or has been rendered. For equity-classified share-based payment awards, this adjustment will include two components: (1) a change in the amount of compensation cost recognized to date on the basis of the grant-date fair-value-based measure (i.e., an adjustment to compensation cost to cumulatively reflect the grant-date fair-value-based measure that should be recognized to date on the basis of the revised estimate of forfeitures) and (2) a change in the amount of compensation cost recognized to date for dividends declared on unvested awards (i.e., an adjustment to compensation cost [and retained earnings] to cumulatively reflect in compensation cost the dividends declared to date on awards that are not expected to vest, on the basis of the revised estimate of forfeitures). This adjustment should not affect previously reported EPS amounts. In the period in which the forfeiture adjustment is made, net income (the numerator) will be affected by the adjustment to compensation cost described above; however, there will be no effect on the application of the two-class method. The two-class method should reflect an allocation of current-period earnings, including the adjustment to compensation cost to reflect the change in estimated forfeitures. ASC 260 does not permit a cumulative adjustment to distributed earnings for a change in estimated forfeitures. Rather, in the period in which an adjustment is made to compensation expense for a change in estimated forfeitures, an entity should continue to allocate distributed earnings to unvested participating share-based payment awards on the basis of the amount of current-period dividends that are recognized in retained earnings for awards that have vested or that are expected to vest.12 The change in estimated forfeitures will also not affect the allocation of undistributed earnings in the period in which the change is made because the allocation of undistributed earnings to participating share-based payment awards does not depend on whether the outstanding awards are expected to vest. In summary, the adjustment that an entity must make to reflect the change in estimated forfeitures affects the entity’s net income during the period but not how the entity applies the two-class method of calculating EPS.
-
-
Entity accounts for forfeitures as they occur — Distributed earnings during a period will equal the current-period dividends on all unvested participating share-based payment awards (i.e., when an entity does not estimate forfeitures, it initially recognizes all dividends on unvested participating share-based payment awards within retained earnings). An entity should also allocate undistributed earnings to all unvested participating share-based payment awards outstanding during the period on the basis of the weighted-average number of awards during the period. Undistributed losses are generally not allocated to share-based payment awards, as discussed in Section 5.5.2.2.
-
Recognition of actual forfeitures — In accordance with ASC 718-10-35-3, an entity is required to recognize the effect of forfeitures as they occur. For equity-classified share-based payment awards, the adjustment recognized to reflect actual forfeitures will include two components: (1) a reduction in compensation cost equal to the amount of the grant-date fair-value-based measure recognized to date on the awards that are forfeited and (2) an increase in compensation cost equal to the amount of dividends declared to date on the awards that are forfeited (i.e., to cumulatively reflect the amount of dividends previously recognized in retained earnings that must be charged to expense because the awards did not vest). This adjustment should not affect previously reported EPS amounts. In the period in which the forfeitures occur and are recognized, net income (the numerator) will be affected by the adjustment to compensation cost described above; however, there will be no effect on application of the two-class method. The two-class method should reflect an allocation of current-period earnings, including the adjustment to compensation cost to reflect actual forfeitures. ASC 260 does not permit cumulative adjustments to distributed earnings to reflect actual forfeitures. Rather, in the period in which an adjustment is made to compensation expense to reflect actual forfeitures, an entity should continue to allocate distributed earnings to all unvested participating share-based payment awards in an amount equal to the current-period dividends declared on such awards. The recognition of forfeitures will also not affect the allocation of undistributed earnings in the period in which forfeitures occur because the allocation of undistributed earnings to participating share-based payment awards does not depend on whether the outstanding awards are expected to vest.
-
Connecting the Dots
The accounting policy an entity elects to account for forfeitures will affect the timing of the
recognition of compensation expense but will have no impact on the cumulative amount
of compensation expense recognized for a grant of equity-classified share-based payment
awards to employees once the requisite service period is completed. Regardless of the policy
an entity elects to account for forfeitures, the cumulative amount of compensation expense
recognized will be based on the awards that vest. While it may be intuitive to think that the
cumulative EPS impact under the two-class method would also be the same regardless of
the policy elected, this is not necessarily true because ASC 260 does not permit a cumulative
adjustment to distributed earnings in a reporting period to reflect the occurrence, or a change
in the estimate, of forfeitures that would have affected the amount of prior-period distributed
earnings. Cumulatively, basic EPS under the two-class method may be lower for an entity that
elects to account for forfeitures as they occur because dividends on awards that are forfeited
will ultimately be reflected in both distributed earnings and compensation cost (i.e., before
forfeiture, the dividends represent distributed earnings, and in the period in which the forfeiture
occurs, those same dividends must be reflected as compensation cost). The same phenomenon
may not occur when an entity estimates forfeitures because dividends on the awards not
expected to vest are initially treated as compensation cost (and therefore did not factor into
distributed earnings). The cumulative differences that could arise between the two approaches (i.e., recognizing forfeitures as they occur vs. estimating forfeitures) will ultimately depend on
the facts and circumstances, including the level of forfeitures and the significance of changes in
estimates when forfeitures are estimated for the purpose of recognizing compensation cost.
The policy election regarding the accounting for forfeitures should not, however, affect the
calculation of diluted EPS under the treasury stock method, which is based on the actual
number of nonforfeited awards regardless of an entity’s accounting policy election related to the
accounting for forfeitures. See ASC 718-10-45-1 for further discussion.
5.5.2.5.3 Mandatorily Redeemable Common Shares and Forward Contracts to Repurchase Common Shares
ASC 480-10
EPS
45-4 Entities that have
issued mandatorily redeemable shares of common
stock or entered into forward contracts that
require physical settlement by repurchase of a
fixed number of the issuer’s equity shares of
common stock in exchange for cash shall exclude
the common shares that are to be redeemed or
repurchased in calculating basic and diluted
earnings per share (EPS). Any amounts, including
contractual (accumulated) dividends and
participation rights in undistributed earnings,
attributable to shares that are to be redeemed or
repurchased that have not been recognized as
interest costs in accordance with paragraph
480-10-35-3 shall be deducted in computing income
available to common shareholders (the numerator of
the EPS calculation), consistently with the
two-class method set forth in paragraphs
260-10-45-60 through 45-70.
Under ASC 480-10-45-4, when an entity has mandatorily redeemable common shares
or a forward purchase contract that must be physically settled by
repurchase of a fixed number of common shares in exchange for cash, the
common shares to be redeemed or repurchased are excluded from the
denominator in the calculation of basic and diluted EPS.13 While the outstanding common shares are excluded from the
denominator in the calculations of EPS, if the counterparty that owns
the common shares has a contractual right to participate in dividends
declared by the entity before the common shares are retired, the entity
must treat the excluded common shares as participating securities under
ASC 260. Under the two-class method, an entity adjusts the numerator for
any dividends declared or paid and undistributed earnings, but only to
the extent that these amounts have not been accounted for as interest
cost. Generally, no distributed earnings will be allocated to these
participating securities because the dividends will have been recognized
in earnings as interest cost; therefore, reflecting the distributed
earnings under the two-class method would result in “double-counting”
the impact on EPS. However, undistributed earnings must be allocated to
these participating securities in accordance with ASC 260-10-45-59A
through 45-70. As discussed in Section 3.2.4.3.1, the impact on
EPS of treating the common shares as participating securities will often
be the same as including the common shares in the denominator in the EPS
calculations when an entity has undistributed earnings. If, however, a
forward purchase contract on a fixed number of common shares contains
fixed adjustments to the forward price that are based on anticipated
dividends, the guidance in Section 5.3.3.5.2 applies and the
forward purchase contract is not a participating security.
ASC 480-10-45-4 only specifically applies to forward purchase contracts that involve the repurchase of
a fixed number of common shares in exchange for cash. The accounting for prepaid forward purchase
contracts that involve the repurchase of a fixed number of common shares and forward purchase
contracts on a variable number of common shares is discussed below.
5.5.2.5.3.1 Prepaid Forward Contracts to Repurchase Common Shares
An entity may enter into a forward contract to purchase a fixed number of common shares in exchange
for cash and prepay the forward price (i.e., a prepaid forward share purchase contract). A prepaid
forward share purchase contract does not meet the criteria to be accounted for as an asset or liability
under ASC 480-10-25-8 because it does not represent an obligation of the issuing entity to transfer
assets. More specifically, because the issuing entity prepays the forward price to the seller of the
common shares, it does not have an obligation to transfer assets in the future. This is the case even if
the entity is required to pay dividends to the counterparty when it declares dividends on its common
stock since an obligation to pay dividends does not exist before declaration.
While ASC 480-10-45-4 does not explicitly apply to prepaid forward share purchase contracts, it is
still generally appropriate to apply that guidance. That is, the common shares to be repurchased are
removed from the denominator in the calculations of basic and diluted EPS and the contract is treated
as a participating security if the counterparty that owns the common shares has a contractual right to
participate in dividends declared by the entity before the common shares are repurchased.
5.5.2.5.3.2 Forward Contracts to Repurchase a Variable Number of Common Shares
The EPS accounting for forward contracts to purchase a variable number of common shares in
exchange for cash depends on the facts and circumstances. If there is a minimum number of common
shares that will be repurchased and those shares have been removed from the denominator in the
calculation of basic and diluted EPS, the entity should apply the two-class method to the number of
common shares removed in a manner consistent with the guidance above if the counterparty has
a contractual right to participate in dividends declared by the entity before the common shares are
repurchased. When common shares are not removed from the denominator, since the common shares
are considered outstanding for EPS purposes, there is no need to treat them as participating securities
and the two-class method should not be applied. See further discussion in Section 3.2.4.3.1.
5.5.2.5.3A Forward Contracts to Sell a Variable Number of Common Shares
Section 5.3.3.5.3 addresses when a VSF contract represents a participating security. As noted in that discussion, if the following two conditions are met, a VSF contract constitutes a participating security and the two-class method of calculating EPS must be applied:
- The VSF contract does not entitle the counterparty to participate in dividends if it is settled within the final range.
- At the inception of the VSF contract, it is not at least reasonably possible that the contract ultimately will be settled within the final range.
When the two-class method of calculating EPS is required for a VSF contract
because it is not at least reasonably possible that the contract
ultimately will be settled within the final range, ASC 260 is not clear
on how earnings should be allocated to the participating security.
Therefore, either of the following two approaches would be acceptable as
an accounting policy election that is consistently applied:
-
Full impact approach — The full amount of distributed and undistributed earnings would be allocated to the VSF contract (i.e., the participating security). As a result, dividends may be allocated to the participating security that are in excess of the economic benefit that the holder receives from the actual and assumed distribution of earnings.
-
Incremental impact approach — The amount for which the VSF contract is considered to participate in earnings should equal the value of the additional common shares that results from distributed and undistributed earnings, under the assumption that all earnings for the period were distributed as dividends. In other words, the amount of participation by the VSF contract would be limited to the economic benefit, if any, to which holders of the VSF contract would be entitled if all earnings were distributed. This approach may involve a calculation of the difference between settlement amounts under the assumption that settlement occurs (1) outside the final range and (2) within the final range.
These same two approaches would also be acceptable if an entity has issued a
mandatorily convertible preferred stock instrument whose range
settlement provisions are similar to those of the VSF contracts
discussed in Section
5.3.3.5.3.
5.5.2.5.4 Participating NCIs and Equity Method Investments
An entity may report an NCI in a consolidated subsidiary (or own an equity
method investee) that has issued participating securities or that has
multiple classes of common stock. In these circumstances, basic and
diluted EPS must be calculated at the subsidiary (investee) level by
using the two-class method to determine the amount of the subsidiary’s
(investee’s) income available to common stockholders that is
attributable to the parent (investor). The parent’s (investor’s) portion
of the EPS amount of the subsidiary (investee) is included in the
numerator in the parent’s (investor’s) calculation of EPS. The parent’s
portion is determined by multiplying the number of shares of the
subsidiary’s (investee’s) common stock owned by the parent by the
subsidiary’s (investee’s) basic and diluted EPS amounts. The product of
these two amounts is included in the numerator in the parent’s
(investor’s) calculation of the consolidated group’s basic and diluted
EPS. In these circumstances, it is necessary to use the two-class method
to calculate the subsidiary’s (investee’s) basic and diluted EPS,
regardless of whether the subsidiary (investee) separately reports EPS.
See further discussion in Section 8.8.1.1.
Special considerations are necessary when an entity has an NCI in a consolidated
subsidiary in the form of common stock and that interest is redeemable
at an amount other than fair value, regardless of whether the redemption
obligation is an obligation of the subsidiary or its parent. In these
situations, the two-class method of EPS must be applied. See further
discussion in Sections
3.2.3.3 and 8.8.4.
An NCI in a consolidated subsidiary in the form of common stock or potential
common stock may participate in the earnings of the parent. An NCI in a
consolidated subsidiary in the form of preferred stock may also
participate in earnings of the parent. In these situations, the parent
should reflect the impact of such participation by applying the
two-class method after it has included its portion of the subsidiary’s
income available to common stockholders in its calculation of income
available to common stockholders. The effect of the participation should
be based on the contractual participating rights of the NCI holder. For
example, if the holder only participates in earnings of the parent that
exclude the net income of the subsidiary, that fact must be taken into
account in the determination of the amount of the parent’s undistributed
earnings that is allocated between the NCI and the parent’s common
stockholders. If the NCI that participates in the parent’s earnings is
also redeemable, the impact of the redemption provisions on the
calculation of the parent’s basic EPS must be considered. The impact of
such a redeemable NCI will depend on whether the NCI is in the form of
common stock or preferred stock. See Section 8.8.4 for additional
discussion of the accounting for redeemable NCIs.
5.5.2.5.5 Master Limited Partnerships
See Section 8.9.3.1
for discussion of the application of the two-class method to MLPs
containing incentive distribution rights that are treated as
participating securities.
5.5.3 Application of Two-Class Method to Multiple Classes of Common Stock
5.5.3.1 Redeemable Common Shares
An entity may have common shares that are redeemable securities. As discussed in Section 3.2.4.2, the
impact of the redemption feature on the calculation of EPS depends on the nature of the redemption
feature (i.e., fair value vs. non–fair value).
If an entity has common shares that are redeemable at fair value, in accordance with ASC 480-10-S99-3A(21), the two-class method of calculating EPS is not required solely because of the redemption
feature in the common stock. Similarly, the two-class method is not required when share-based
payment awards granted to employees are redeemable at fair value (provided that those awards are
in the form of common shares or options on common shares). However, an entity may be required to
apply the two-class method if it has determined that, for reasons other than the fair value redemption
feature, it has multiple classes of common stock or if it has determined that a share-based payment
award is a participating security. If the two-class method is applied for reasons other than the fair value
redemption feature, any change in the carrying amount to reflect the fair value redemption under the
subsequent-measurement guidance in ASC 480-10-S99-3A should not be treated as a dividend or
distributed earnings.
If an entity has common shares that are redeemable at any amount other than fair
value, in accordance with ASC 480-10-S99-3A(21), the entity must apply the
two-class method and any increase in the carrying amount of the redeemable
common stock under the subsequent-measurement guidance in ASC 480-10-S99-3A
should be treated as a dividend. Changes in the carrying amount of the
redeemable common stock should not affect income available to common
stockholders but should be treated as distributed earnings under the
two-class method. The SEC staff believes that to the extent that a common
shareholder has a contractual right to receive, at share redemption (in
other than a liquidation event that qualifies for the exception in ASC
480-10-S99-3A(3)(f)), an amount that is other than the fair value of the
common shares, that common shareholder has, in substance, received a
distribution different from that of other common shareholders. Under ASC
260-10-45-59A, entities with capital structures that include a class of
common stock with dividend rates that differ from those of another class of
common stock, but without prior or senior rights, should apply the two-class
method of calculating EPS. As discussed in Section 3.2.4.2, there are two methods
an entity may apply to determine the amount of any increase in the carrying
amount of common stock redeemable at an amount other than fair value that is
treated as a dividend or distributed earnings under the two-class
method.
In addition to the impact of distributed earnings, when the two-class method is applied, the entity must
allocate undistributed earnings (losses) to the redeemable common shares. See Section 3.2.4.2 for
further discussion of redeemable common securities.
5.5.3.2 Multiple Classes of Common Stock With the Same Rights to Distributions
As discussed in Section
5.4.1, in the calculation and presentation of EPS, an entity
may have multiple classes of common stock even if each class has the same
dividend rate. Since basic and diluted EPS must be presented for each class,
the entity should use the two-class method to calculate EPS. Since the
allocation of undistributed earnings is based on a hypothetical assumption
of the distribution of earnings on the basis of the weighted-average shares
of each class of common stock outstanding, in the calculation of basic EPS,
in the absence of participating securities that affect only one class, the
undistributed EPS of each class would generally be expected to be the same.
However, the distributed earnings allocated to each class must be based on
the actual dividends declared (or other distributions made) during the
financial reporting period. Thus, the distributed earnings component per
share will be the same for each class only when the actual and
weighted-average shares of each class are the same during the financial
period. When the actual and weighted-average shares of each class are not
the same, the basic EPS for each class of common stock would not be expected
to be the same, even though each of these classes of common stock has the
same contractual right to dividends (i.e., the same dividend rate per
share).
In addition, diluted EPS under the two-class method could also differ for each class depending on the
facts and circumstances, including the nature of securities and potential common shares in an entity’s
capital structure. See Section 5.5.4 for further discussion of the calculation of diluted EPS under the
two-class method.
5.5.3.3 Allocating Undistributed Losses When an Entity Has Multiple Classes of Common Stock
When an entity’s capital structure includes multiple classes of common stock to
which it must apply the two-class method, and the entity reports
undistributed losses, questions have arisen regarding whether each class of
common stock should participate in the allocation of the undistributed
losses. The guidance in ASC 260-10-45-67 and 45-68 on whether participating
securities absorb undistributed losses is not relevant to the allocation of
undistributed losses to a class of common stock but should be applied only
to participating securities (i.e., securities in a form other than an
outstanding common share). When an entity has multiple classes of common
stock, undistributed losses should be allocated to each class on the basis
of on their contractual terms, regardless of whether the classes have
specifically stated contractual obligations to absorb losses. However, the
allocation of undistributed losses may differ from the allocation of
undistributed earnings. For example, if an entity has two classes of common
stock that share equally in the entity’s residual net assets on liquidation
but have different participation rights to dividends, the entity should
allocate undistributed losses equally to each class. If, however, the rights
to share in the distribution of the residual net assets of the entity are
unequal between the classes, the entity should generally allocate
undistributed losses in accordance with the contractual distribution rights
upon liquidation.14 The entity should also carefully consider whether any liquidation
preference causes one of the classes to be more representative of a
preferred security for EPS purposes (see Section 3.1.1).
5.5.3.4 One Class of Common Stock Is Convertible Into Another Class
An entity may have two classes of common stock in which one class is convertible into the other class.
For this purpose, we refer to the class that is convertible into the other class as the “convertible class”
and the class of common stock into which the convertible class is convertible as the “main class.”
At the 2006 AICPA Conference on Current SEC and PCAOB Developments, Cathy Cole,
then associate chief accountant in the SEC’s Office of the Chief Accountant,
gave a speech addressing how an entity should apply ASC 260
when it has one class of common stock that is convertible into another
class. Ms. Cole stated that the SEC staff believes that an entity must use
the two-class method to present basic EPS for each class of common stock.
ASC 260 prohibits an entity from applying the if-converted method to the
convertible class or the main class in the calculation of basic EPS.
In these situations, an entity must also present diluted EPS for each class. Ms. Cole explained that an
entity should use the if-converted method when calculating diluted EPS of the main class, provided that
the conversion of the convertible class into the main class is dilutive (and that the if-converted method
is more dilutive than the two-class method of calculating diluted EPS). An entity should not apply the
if-converted method in calculating diluted EPS of the convertible class. Rather, diluted EPS for the
convertible class should be calculated by using the two-class method, as if all earnings were distributed
to each class of common stock on the basis of their contractual rights. For this purpose, an entity must
consider potential common shares of the convertible class by using the treasury stock method, the
if-converted method, or the contingently issuable share method, as applicable (see Section 5.5.4 for
further discussion of the application of the two-class method to the calculation of diluted EPS).
Ms. Cole referred to an example in which Class B common shares are convertible into Class A common
shares and stated, in part:
The first situation relates to diluted [EPS] when one class of common is
convertible into another class of common. [ASC 260] requires the use
of the two-class method of computing EPS in certain circumstances,
namely, when there is more than one class of common stock and the
classes have different dividend rates or when there are other
securities that have a right to participate in dividends with common
stock. . . .
As an example, a company may have two classes of common stock, say Class A and
Class B. Class A may be entitled to dividends at a rate that is 1.2
times that of Class B, but Class B may have twice the voting rights
of Class A. Class B may also be convertible at any time into Class A
on a 1 to 1 basis. . . .
[T]he staff believes that for diluted EPS, a company with two classes of common stock must actually present
both a basic and diluted earnings per share number for each class of common stock regardless of conversion
rights. One might ask, “If for diluted EPS, I have assumed the conversion of one class into the other, how can
I then present two diluted earnings per share numbers, one for each class? Doesn’t assuming the conversion
of one class into the other essentially eliminate the second class for diluted EPS purposes?” Well, for the
class being converted into (Class A in the example), we believe diluted EPS should be computed using the
if-converted method for the convertible class (Class B), if doing so would be dilutive. Diluted EPS for the
convertible class (Class B in the example) should be computed using the two-class method. Diluted EPS must
be presented for both classes.
You may ask, “What is the point of this second computation?” Why can’t the company just present diluted EPS
for Class A and be done with it? Well, there are several reasons for the presentation of diluted EPS for Class B.
The first reason is that while presenting diluted EPS for Class A assuming conversion of Class B may be more
dilutive for Class A, the assumed conversion might in fact be antidilutive for Class B. In our simple example, if
Class A is entitled to $1.20 of dividends for every $1.00 of dividends for Class B, then if Class B is allowed to share equally in earnings with Class A, then Class B would be entitled to a higher share of earnings on a diluted
basis assuming conversion, than it would be entitled to absent the conversion. Further, Class B shareholders
might be interested in knowing what diluted EPS would be for Class B shares, if the shares were not converted
into Class A. This might be especially true in circumstances where potential common shares would also affect
the computation.
The second reason for presenting EPS for Class B is that presenting diluted EPS only for Class A is inconsistent
with the guidance of [ASC 260-10-45-60B], which that says that basic and diluted EPS data should be presented
for each class of common stock. Thus, if there are two classes of common stock that means two sets of EPS
data. I just think of it as double the numbers . . . double the fun. Obviously though, the company should also
provide the appropriate footnote disclosures explaining its computation of basic and diluted EPS.
The SEC staff’s view is an appropriate interpretation of ASC 260 and should be
applied by all entities that present EPS under ASC 260.
In her remarks at the 2006 AICPA Conference, Ms. Cole also addressed the SEC
staff’s views on a particular scenario involving the application of the
two-class method by an entity that has two classes of common stock. She
stated:
There were two classes of common stock, let’s call
these A and B. Class A was entitled to one vote per share; Class B
was entitled to ten votes per share. The company’s articles of
incorporation stated that dividends could be paid on Class A without
an equal or any dividend being paid on Class B. However, dividends
could not be paid on Class B without an equal amount being paid on
Class A. Further, Class B was convertible into Class A on a 1-to-1
basis at any time. And, Class B common stock controlled
approximately 75% of the shareholder votes of the company. Classes A
and B shared equally in the net assets of the company on
liquidation. The company had historically paid dividends equally to
both classes. In applying the two-class method, the company had
allocated the undistributed earnings equally on a per share basis to
both classes.
In this case, there was no contractually
predetermined ratio of dividends between the classes of common
stock. [ASC 260], if applied literally in this situation, would have
resulted in no allocation of undistributed earnings to the Class B
common stock. Since the articles of incorporation provided that all
the earnings could be entirely distributed to Class A without any
distribution to Class B, no allocation would be made to Class B.
[ASC 260-10-45-65] states that “ . . . if an entity could avoid
distribution of earnings to a participating security, even if all of
the earnings for the year were distributed, then no allocation of
that period’s earnings to the participating security would be
made.”
However, company management believed it was
appropriate to allocate undistributed earnings between the two
classes on a 1-to-1 basis. Management believed that the allocation
of undistributed earnings must be done considering all of the rights
and privileges of the different shareholder groups. They thought
that it was unreasonable to think that the Class B common
stockholders that control the Board would systematically allow the
Board to pay dividends on Class A shares without paying them on
Class B as well. Also, since the Class B was convertible at any time
into Class A, the Class B stockholders could convert and capture any
differential dividend, after it was declared. But, although Class B
controlled the Board, the Board could not pay dividends on Class B
without paying an equal amount on Class A.
After additional consideration and consultation, we
came to believe that the particular facts in this case justified a
different answer from a strict application of [ASC 260]. The SEC
staff believes that the [guidance on the two-class method] was
generally written in the context of classes of participating
securities that do not control the company and that applying [such
guidance] by analogy in this case did not produce the most
transparent reporting. Thus, the staff did not object to the
company’s judgment on how to apply the two-class method in this
case. We did suggest that the company provide disclosures of the
factors it considered in determining that its methodology was
appropriate.
This view is also an appropriate interpretation of ASC 260 that should be
applied by all entities that present EPS under ASC 260.
5.5.3.5 Master Limited Partnerships
See Section 8.9.3.1
for discussion of the application of the two-class method to MLPs that
contain incentive distribution rights that are treated as part of the
general partner’s interest.
5.5.4 Calculation of Diluted EPS Under the Two-Class Method
ASC 260 does not specifically address how to apply the two-class method to the calculation of diluted EPS. In practice, however, entities have applied the approach outlined in proposed FASB FSP FAS 128-a. Under that approach, an entity applies the following three-step process to calculate diluted EPS under the two-class method:
- Step 1 — Use the two-class method to calculate basic EPS.
- Step 2 — Use the total earnings allocated to common stock in step 1 to determine diluted EPS. If a participating security is also a potential common share, separately perform steps 2a and 2b to determine the dilutive effect.
- Step 2a — Assume that the participating security has been exercised, converted, or issued; that is, apply the treasury stock method, the if-converted method, or the contingently issuable share method.
- Step 2b — Add back the undistributed earnings allocated to the participating security (or securities) in arriving at basic EPS, and assume that all other dilutive potential common shares have been exercised, converted, or issued in order of antidilution. Next, reallocate the undistributed earnings — including any additional income that would result from the exercise, conversion, or issuance of potential common shares — to the (1) common shares and potential common shares and (2) participating security (or securities).
- Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
The following should be noted regarding this three-step process:
- While step 2b requires a reallocation of undistributed earnings to common shares, potential common shares, and participating securities that are not assumed exercised, converted, or issued under step 2a, it is never appropriate to reverse or reallocate distributed earnings.
- As discussed in Section 4.7.3, for certain contracts that are assumed to be share-settled for diluted EPS purposes, an adjustment must be made to the numerator. The amount of this numerator adjustment would affect the amount of undistributed earnings to be reallocated under step 2b.
Further, an entity that has multiple classes of common stock must calculate diluted EPS for the second
class of common stock by using the two-class method, under an assumption that additional common
shares of the first class of common stock are outstanding as a result of the conversion of all potential
common shares outstanding. In such circumstances, the entity is required to reallocate undistributed
earnings to the second class of common stock. If there are potential common shares related to the
second class of common stock, diluted EPS reflects the more dilutive of the two-class method or the
applicable dilutive method (e.g., the treasury stock, if-converted, or contingently issuable share method)
for the second class of common stock.
While diluted EPS for the first class of common stock may reflect the conversion of the second class of
common stock into the first class of common stock, such conversion may not be assumed for diluted
EPS for the second class of common stock.
5.5.5 Examples
ASC 260 contains two examples illustrating the calculation of basic EPS under the two-class method
when there are participating securities outstanding. Those examples are reproduced below.
ASC 260-10
Example 6: Two-Class Method
55-62 This Example illustrates the two-class method of computing basic EPS (see paragraph 260-10-45-60B)
for an entity that has more than one class of nonconvertible securities. This method is described in paragraphs
260-10-45-59A through 45-70. Diluted EPS would be computed in a similar manner. This Example has the
following assumptions for the year 20X0:
- Net income was $65,000.
- 10,000 shares of $50 par value common stock were outstanding.
- 5,000 shares of $100 par value nonconvertible preferred stock were outstanding.
- The preferred stock was entitled to a noncumulative annual dividend of $5 per share before any dividend is paid on common stock.
- After common stock has been paid a dividend of $2 per share, the preferred stock then participates in any additional dividends on a 40:60 per-share ratio with common stock. (That is, after preferred and common stock have been paid dividends of $5 and $2 per share, respectively, preferred stock participates in any additional dividends at a rate of two-thirds of the additional amount paid to common stock on a per-share basis.)
- Preferred stockholders have been paid $27,000 ($5.40 per share).
- Common stockholders have been paid $26,000 ($2.60 per share).
55-63 Basic EPS for 20X0 would be computed as follows.
Example 9: Participating Securities and the Two-Class Method
55-71 Participating
securities should be included in the computation of
basic earnings per share using the two-class method. The
following Cases illustrate the guidance in paragraphs
260-10-45-59A through 45-70 for the application of the
two-class method of computing basic earnings per share
when:
-
An entity has participating convertible preferred stock (Case A).
-
An entity has participating convertible bonds (Case B).
-
An entity has participating warrants (Case C).
-
An entity has participating share-based payment awards (Case D).
55-72 The application of the two-class method in each of Cases A, B, and C presents an EPS calculation for
both the common stock and the participating security. This presentation is for illustrative purposes only. The
presentation of EPS is only required for each class of common stock (as clarified by this Example). However, the
presentation of basic and diluted EPS for a participating security other than common stock is not precluded.
Cases A, B, and C share both of the following assumptions:
- 10,000 shares of Class A common stock
- Reported net income of $65,000 for 20X1.
Case A: Participating Convertible Preferred Stock
55-73 Assume that Entity A had 5,000 shares of preferred stock outstanding during 20X1. Each share of
preferred stock is convertible into two shares of Class A common stock. The preferred stock is entitled to a
noncumulative annual dividend of $5 per share. After Class A has been paid a dividend of $2 per share, the
preferred stock then participates in any additional dividends on a 40:60 per share ratio with Class A. For 20X1,
the Class A shareholders have been paid $26,000 (or $2.60 per share), and the preferred shareholders have
been paid $27,000 (or $5.40 per share). Basic EPS under the two-class method for 20X1 would be computed as
follows.
Case B: Participating Convertible Debt Instrument
55-74 Assume that on January 1, 20X1, Entity A issues 1,000 30-year convertible bonds with an aggregate par
value of $1,000,000. Each bond is convertible into 8 shares of Class A common stock and carries a coupon
rate of 3 percent. After Class A has been paid a dividend of $2 per share, the bondholders then participate
in any additional dividends on a 40:60 per share ratio with Class A shareholders. The bondholders receive
common stock dividends based on the number of shares of common stock that the bonds are convertible
into. The bondholders do not have any voting rights prior to conversion into common stock. For 20X1, the Class
A shareholders have been paid $20,000 (or $2.00 per share). Basic EPS under the two-class method for 20X1
would be computed as follows.
Case C: Participating Warrants
55-75 Assume that Entity A had warrants to purchase 5,000 shares of common stock outstanding during 20X1.
Each warrant entitles the holder to purchase 1 share of common stock at $10 (fair value at date of grant) per
share. In addition, the warrant holders receive dividends on the underlying common stock to the extent they
are declared. For 20X1, common shareholders have been paid $26,000 (or $2.60 per share), and the warrant
holders have been paid $13,000 (or, also, $2.60 per share). Basic EPS under the two-class method for 20X1
would be computed as follows:
Case D: Participating Share-Based Payment Awards
55-76A Assume that Entity A had 25,000 shares of common stock and 5,000 unvested share-based payment
awards outstanding during 20X8 and reported net income of $100,000. The share-based payment awards
participate in any dividends on a 1:1 per-share ratio with common stock, and the dividends are nonforfeitable
by the holder of the share-based payment awards. Entity A’s accounting policy is to estimate the number of
forfeitures expected to occur in accordance with paragraph 718-10-35-3.
55-76B As of the beginning of 20X8, Entity A estimated that the requisite service will not be provided for 200 of
the 5,000 share-based payment awards outstanding. At the end of 20X8, Entity A adjusts its estimate to reflect
an increased expected forfeiture rate and now expects that the requisite service will not be provided for 300
awards. It recognizes the cumulative effect of this change in compensation cost in the current period.
55-76C Entity A paid a $1.50 per-share dividend at the end of 20X8. Net income includes an expense of $450
related to dividends paid to the awards for which the requisite service is not expected to be rendered in
accordance with paragraph 718-10-55-45. Basic EPS under the two-class method for 20X8 would be computed
as follows:
55-76D Note that in this illustrative example, application of the two-class method presents an EPS calculation
for both the common stock and the participating security, that is, the unvested share-based payment awards.
This presentation is for illustrative purposes only. The presentation of EPS is only required for each class of
common stock. However, the presentation of basic and diluted EPS for a participating security other than
common stock is not precluded. The disclosure in the notes to financial statements of actual distributions
to unvested share-based payment awards, rather than the amount presented as distributed earnings,
also is not precluded to reconcile earnings per common share and per unvested share-based payment
awards. For example, Entity A in the example above may disclose that actual distributions to unvested share-based
payment awards were $7,500 and that $450 of those distributions was included in net income as
compensation cost related to awards for which the requisite service is not expected to be rendered. Disclosure
on a per-share basis also is not precluded.
Below are additional examples illustrating the application of the two-class method.
Example 5-14
Allocation of Undistributed Earnings to Entity With “Waterfall” Formula
Entity C’s capital structure consists entirely of 1 million shares of Class A common stock and 1 million shares
of Class B common stock. Each Class A and Class B share is entitled to one vote on any matter submitted to a
vote of shareholders. Entity C’s certificate of incorporation specifies that C will make annual distributions on the
basis of the following waterfall allocation:
- First, Class A receives $0.25 per share.
- Next, Class B receives $0.25 per share.
- Last, earnings are distributed 40:60 to Class A and Class B on a per-share basis.
During the year ended December 31, 20X1, C reports the following amounts of net income:
Entity C makes distributions annually in March from the prior year’s earnings. The total amount distributed
must be approved by a majority vote of the Class A and Class B shareholders. According to C’s shareholder
agreement, the total distribution will equal the prior year’s distributable cash less any reserves approved
for future expenditures. Such distributions are not approved until after the audited financial statements for
the prior year are issued. This example is not intended to address whether C should calculate an amount of
distributed earnings during the current year or how C should treat any current-year distributions of prior-year
earnings. To determine these matters, an entity would need to use judgment and consider the relevant facts
and circumstances related to distributions. In this example, it is first assumed that there are no distributed
earnings for the year. The example then addresses how the EPS amounts would change if the current-year
earnings were considered distributed earnings during the fourth quarter.
No Distributed Earnings
For the annual period, C would allocate earnings under the two-class method of calculating basic and diluted
EPS as follows (note that the results would be the same if the earnings for the year were distributed earnings
for the fourth quarter):
For the annual period, basic and diluted EPS for each class of common stock would be calculated as follows:
The calculation of basic and diluted EPS for each interim period during the year
depends on which method in Section 5.5.1.1 is
applied (i.e., because the distributions are determined
on the basis of a waterfall that depends on the annual
period, the two views discussed in Section 5.5.1.1 are
acceptable). The allocation of undistributed earnings
according to the two views is as follows:
View A — Discrete-Period Basis
Under the discrete-period approach, it is assumed that earnings for each interim period are distributed in
accordance with the contractual distribution rights of each class of common stock as if the waterfall distribution
applied to the earnings for the interim period. As a result, Class B only receives a distribution in an interim
period in which undistributed earnings exceed $250,000.
View B — Cumulative-Period Basis
Under the cumulative-period approach, it is assumed that earnings on an interim basis are distributed in
accordance with the contractual distribution rights of each class of common stock in a manner consistent with
the application of the waterfall distribution to annual earnings. As a result, the allocation of earnings in quarters
after the first quarter is based on the cumulative amounts that would be allocated on the basis of the year-to-date
earnings. The distributions are as follows:
- First quarter — All of the first-quarter earnings are allocated to the Class A common stock because it is entitled to the first $250,000 of distributions.
- Second quarter — All of the second-quarter earnings are allocated to the Class B common stock because it is entitled to the next $250,000 of distributions. Since there was only $200,000 of earnings during the second quarter, the next $50,000 of earnings is carried over for allocation to Class B.
- Third quarter — Class B is entitled to the first $50,000 of the earnings for the third quarter. The remaining $250,000 is allocated on a 40:60 basis to Class A and Class B, resulting in the allocation of $100,000 and $150,000 of the remaining earnings to Class A and Class B, respectively.
- Fourth quarter — The $250,000 is allocated on a 40:60 basis to Class A and Class B, resulting in the allocation of $100,000 and $150,000 of the earnings to Class A and Class B, respectively.
According to the two views, basic and diluted EPS for the interim periods is as follows:
Under View B, the aggregate interim-period EPS amounts equal the annual amounts. This may not always be
the case. Under View A, the aggregate interim-period EPS amounts would not be expected to equal the annual
amounts.
Distributed Earnings
If the current-year earnings were distributed earnings in the fourth quarter (i.e., C declared a distribution, or it
was concluded that $1 million was equal to distributable cash for the year for which distribution was required),
the interim-period EPS for the first three quarters would not change according to each view. The fourth-quarter
EPS amounts would be as follows:
View A — Discrete-Period Basis
The EPS amounts for each class depend on how the Class A and Class B shares absorb undistributed losses.
Assume that the proceeds on liquidation are allocated pari passu (50:50) to each class. The EPS amounts would
be as follows:
Assume that the proceeds on liquidation are allocated in accordance with the 40:60 allocation of residual
earnings under the waterfall distribution. The EPS amounts would be as follows:
View B — Cumulative-Period Basis
The EPS amounts for each class would be unchanged from the fourth-quarter amounts under View B when
there were no distributed earnings because the earnings allocation is based on an annual distribution
approach. The distributed and undistributed earnings components for the fourth quarter would be as follows:
Example 5-15
Application of Two-Class Method — Interim and
Year-to-Date Basis
Entity R, a real estate investment trust, is required to
distribute at least 90 percent of its taxable income.
Entity R has the following classes of equity securities outstanding:
- One million shares of common stock.
- One million shares of participating cumulative preferred stock.
The preferred stock ranks senior to the
common stock with respect to the rights to receive
dividends and to participate in distributions upon
liquidation. Dividends on the preferred stock are paid
monthly. Holders of preferred stock are entitled to
receive, in preference and before any payment of
dividends on common stock, a monthly dividend of $1.50
per share ($18.00 per share, per annum). After payment
of this amount, holders of preferred stock are entitled
to participate in dividends paid on common stock on an
as-converted basis. The preferred stock does not absorb
any undistributed losses. The preferred stock is
convertible into 500,000 shares of common stock.
Assume the following for the six months ended June 30,
20X9:
- First quarter ended March 31, 20X9:
- Entity R’s net income was $20 million.
- Entity R declared $18 million
of dividends, consisting of the following:
- $4.5 million on the preferred stock at the stated monthly rate (1,000,000 × $1.50 × 3).
- $4.5 million on the preferred stock (based on participation in dividends declared on common stock).
- $9 million on common stock.
- Second quarter ended June 30, 20X9:
- Entity R’s net income was $3 million.
- Entity R declared $4.5 million of dividends, consisting only of the dividends on the preferred stock at the stated monthly rate (1,000,000 × $1.50 × 3).
On the basis of the above facts, R
would report the following amounts of basic EPS for the
quarterly and year-to-date periods:
Example 5-16
Application of Two-Class Method When Distributions Exceed
Earnings
Entity A has 1 million weighted-average common shares outstanding for the fiscal year ended December
31, 20X1, and current-period net income of $2 million. On January 1, 20X1, A issues 100,000 convertible
preferred securities. Each preferred share is convertible into two shares of A’s common stock. The preferred
shareholders are entitled to a noncumulative annual dividend of $5 per share before any dividend is paid
to the common shareholders. After the common shareholders are paid a dividend of $2 per share, the
preferred shareholders participate in any remaining undistributed earnings on a 40:60 per-share basis with
the common shareholders. Accordingly, the preferred securities are participating securities for which A must
use the two-class method to calculate basic and diluted EPS. However, the contractual terms of the preferred
securities do not address whether they would participate in the entity’s losses. In fiscal year 20X1, A declared
and paid $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2 dividend for common
shareholders).
Undistributed losses should be calculated under the two-class method as follows:
Undistributed losses should be allocated as follows:
- To participating convertible preferred shares — Because the contractual terms of the preferred securities do not address whether the preferred shareholders would participate in the entity’s losses, the undistributed losses should be allocated only to the common shareholders.
- To common shares — ($500,000) ÷ 1,000,000 weighted-average common shares outstanding = ($0.50) per share.
Amounts of basic EPS would be as follows:
Example 5-17
Application of Two-Class Method When Distributions Exceed Earnings for Share-Based Payment
Awards
Entity B has 1 million weighted-average common shares outstanding for the fiscal year ended December 31,
20X1, and current-period net income of $1 million. On January 1, 20X1, A issues 250,000 nonvested share-based
payment awards to its employees. Holders of nonvested shares have a nonforfeitable right to receive
cash dividends on a 1:1 per-share basis with the common shareholders. Accordingly, the nonvested shares
are participating securities for which A must use the two-class method to calculate basic and diluted EPS.
The contractual terms of the nonvested shares do not address whether they would participate in the entity’s
losses. In fiscal year 20X1, A declares and pays $2.5 million in dividends for both the common shares and the
nonvested shares (or a $2 dividend for both the common shareholders and holders of the nonvested share-based
payment awards).
Undistributed losses should be calculated under the two-class method as follows:
Undistributed losses should be allocated as follows:
- To nonvested shares — Because the contractual terms of the nonvested shares do not address whether the holders of nonvested share-based payment awards would participate in the entity’s losses, the undistributed losses should be allocated only to the common shareholders.
- To common shares — ($1,500,000) ÷ 1,000,000 weighted-average common shares outstanding = ($1.50) per share.
Example 5-18
Participation Contingent on Stock Price
Entity B, which has a calendar year-end, has outstanding convertible preferred stock that entitles the holders to
participate in dividends on common stock on a one-for-one share-equivalent basis with common shareholders
at any time dividends are declared, provided that the fair value of B’s common stock exceeds $25 per share for
any three consecutive days during the period within the current fiscal year since dividends were last declared.
If the market price contingency is met (i.e., the fair value of B’s common stock exceeds $25 per share for any
three consecutive days in the reporting period), the two-class method should be applied to the convertible
preferred stock for the financial reporting period on the basis of an assumption that all earnings for the period
have been distributed (regardless of whether any dividends actually have been declared). This treatment is
consistent with how earnings would be allocated between the common stock and convertible preferred stock if
all earnings for the period were actually distributed.
Assume that during the first quarter ended March 31, 20X1, the fair value of B’s common stock did not exceed
$25 for any three-consecutive-day period, but that for the second quarter ended June 30, 20X1, the fair value
of B’s common stock did exceed $25 for a three-consecutive-day period. Further assume that B did not declare
or pay any dividends on common stock during the year. For B’s calculation of EPS for the first quarter ended
March 31, 20X1, no undistributed earnings should be allocated to the convertible preferred stock because
the market price contingency has not been met. For B’s calculation of EPS for the second quarter ended June
30, 20X1, undistributed earnings should be allocated to the convertible preferred stock because the market
price contingency has been met. Since the allocation of undistributed earnings on a year-to-date basis is
determined on an independent, or discrete, basis, as discussed in Section 5.5.1.1, B should also allocate all
the undistributed earnings for the year-to-date period to the convertible preferred stock in calculating EPS
for the six-month period ended June 30, 20X1. This allocation of undistributed earnings is consistent with the
contractual participation terms of the convertible preferred stock.
Note that while market price contingencies are generally assessed at the end of the reporting period in the
calculation of EPS, in this example, the market price contingency must be assessed over the reporting period
on the basis of the contractual participation terms of the convertible preferred stock.
Example 5-19
Allocation of Earnings to Participating Debt
Entity D has the following outstanding securities in its capital structure:
- 1 million common shares.
- $10 million principal amount of senior notes (the “notes”).
The notes pay interest quarterly, in arrears, at a rate of 2.5 percent per annum. The holders of the notes are
also entitled to participate in dividends declared on D’s common stock on a 40:60 basis.
During the quarter ended December 31, 201X, D earns $15 million of pretax income before recognition of
interest expense on the notes. Entity D accrues $62,500 of interest on the notes in accordance with the stated
interest rate on the notes and declares dividends of $1,000,000, which, in accordance with the participation
rights of the notes, is payable in an amount of $400,000 on the notes and $600,000 on the common shares.
Assume that D’s tax rate is 25 percent.
On the basis of the above facts, D would report net income for the period of $10,903,125.(a) Entity D would
calculate distributed and undistributed earnings as follows:
In accordance with the contractual participation rights of the notes, $4,121,250(b) of the undistributed earnings
should be allocated to the notes and $6,181,875(c) to the common shares. Total earnings attributable to the
common shares are $6,781,875,(d) resulting in earnings per common share of $6.78.(e)
Note that in D’s application of the two-class method of calculating EPS, the $400,000 of distributed earnings to
the holders of the notes, based on the contractual right of the noteholders to participate in dividends declared
during the period, should not be reduced from the numerator (i.e., net income) because this amount has been
treated as interest cost and has reduced net income. Income available to common stockholders (net income in
this example) should be reduced only for undistributed earnings attributable to the noteholders because any
reflection of $400,000 as distributed earnings would result in “double-counting” the impact of this participation
in the calculation of EPS.
____________________
(a) $15,000,000 – $62,500 – $400,000 = $14,537,500 × 75% = $10,903,125. (Note
that the $400,000 in dividend equivalents paid on the
notes must be accounted for as interest expense since
the notes are classified as a liability.)
(b) $10,303,125 × 0.4 = $4,121,250.
(c) $10,303,125 × 0.6 = $6,181,875.
(d) $600,000 + $6,181,875 = $6,781,875.
(e) $6,781,875 ÷ 1,000,000 = $6.78.
Example 5-20
Allocation of Earnings to Participating Noncumulative Preferred Stock
Entity E has the following outstanding securities in its capital structure:
- One million common shares.
- 500,000 shares of Series A convertible preferred stock (the “preferred stock”).
The preferred stock is convertible into common stock on a 1:1 basis. Each holder of preferred stock is entitled
to receive noncumulative preferred dividends of $0.08 per share. After payment of the $0.08 noncumulative
dividend, any additional dividends are distributed between the common shareholders and preferred
stockholders (on an as-converted basis) on a 1:1 basis. Entity E has not declared any dividends, and does not
intend to pay or declare any dividends in the future, on any class of stock. For the year ended December 31,
20X1, E had net income of $5 million.
On the basis of the above facts, the preferred stock is a participating security. Accordingly, E is required to
calculate basic and diluted EPS under the two-class method. In applying the two-class method, E would first
determine the amount of noncumulative dividends that would be allocated to the preferred stock (i.e., $0.08
per share or $40,000). Any remaining earnings would be allocated to the common stock and preferred stock
(on an as-converted basis) on a 1:1 basis. On an as-converted basis, 500,000 shares of common stock would
be issued for the preferred stock. Compared with the 1 million outstanding common shares, the holders of the
preferred stock would be entitled to one-third of the undistributed earnings, or $1,653,333.(a) Total distributed
and undistributed earnings allocated to the preferred stock are $1,693,333,(b) as a result of which the common
shareholders would receive total earnings of $3,306,667(c) and basic EPS would be $3.31.(d)
____________________
(a) $5,000,000 – $40,000 = $4,960,000 × 1/3 = $1,653,333.
(b) $40,000 + $1,653,333 = $1,693,333.
(c) $5,000,000 – $40,000 = $4,960,000 × 2/3 = $3,306,667.
(d) $3,306,667 ÷ 1,000,000 = $3.31.
Example 5-21
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Convertible
Preferred Stock
Assume that Entity A has 1 million weighted-average common shares outstanding for the fiscal year ended
December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, A issues 100,000 convertible preferred securities. Each preferred share is convertible into
two shares of A’s common stock. The preferred shareholders are entitled to a noncumulative annual dividend
of $5 per share before any dividend is paid to the common shareholders. After the common shareholders
are paid a dividend of $2 per share, the preferred shareholders participate in any remaining undistributed
earnings on a 40:60 per-share basis with the common shareholders. Accordingly, the preferred securities are
participating securities for which A must use the two-class method to calculate basic and diluted EPS. In fiscal
year 20X1, A declares and pays $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2
dividend for common shareholders).
The calculations under the two-class method are as follows:
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Since there are no potential common shares other than the participating convertible preferred shares,
antidilution sequencing is not required.
Calculation of diluted EPS for the common shares in which the use of the if-converted method for the participating
convertible preferred shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Because A’s capital structure only includes common shares and participating convertible preferred shares (i.e.,
there are no other potential common shares), basic and diluted EPS under the two-class method would be the
same ($4.34).
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, A would disclose an amount of diluted EPS per common share that would result from applying
the if-converted method ($4.17) because that amount is more dilutive than the amount that would result from
applying the two-class method ($4.34). In accordance with ASC 260-10-45-60, A would be permitted, but not
required, to present basic and diluted EPS for the participating convertible preferred shares on the face of the
income statement. For more information, see Section 9.1.4.
Example 5-22
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Convertible
Preferred Stock With Convertible Debt and Warrants
Assume that Entity B has 1 million weighted-average common shares stock outstanding for the fiscal year
ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, B issues 100,000 convertible preferred securities. Each preferred share is convertible into
two shares of B’s common stock. The preferred shareholders are entitled to a noncumulative annual dividend
of $5 per share before any dividend is paid to the common shareholders. After the common shareholders
are paid a dividend of $2 per share, the preferred shareholders participate in any remaining undistributed
earnings on a 40:60 per-share basis with the common shareholders. Accordingly, the preferred securities are
participating securities for which B must use the two-class method to calculate basic and diluted EPS. In fiscal
year 20X1, B declares and pays $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2
dividend for common shareholders).
In addition, assume the following:
- On January 1, 20X1, B issues warrants to purchase 100,000 shares of its common stock at $50 per share for a period of five years. The average market price of B’s stock price for 20X1 is $60 per share. The warrants do not meet the definition of a participating security.
- On January 1, 20X1, B issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of B’s common stock and bears an interest rate of 3 percent. The convertible bonds do not meet the definition of a participating security.
The calculations under the two-class method are as follows:
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
This calculation is the same as the calculation of basic EPS in Example
5-21, because basic EPS is not affected
by the warrants and convertible debt since neither
security is a participating security.
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Calculation of diluted EPS for the common shares in which the use of the if-converted method for the participating
convertible preferred shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, B would disclose an amount of diluted EPS per common share that would result from applying
the if-converted method ($3.81) because that amount is more dilutive than the amount that would result from
applying the two-class method ($3.92). In accordance with ASC 260-10-45-60, B would be permitted, but not
required, to present basic and diluted EPS for the participating convertible preferred shares on the face of the
income statement. See further discussion in Section 9.1.4.
Example 5-23
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Nonvested Share-Based Payment Awards
Assume that Entity C has 1 million weighted-average shares of common stock outstanding for the fiscal year
ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, C issues 250,000 nonvested share-based payment awards to its employees. The nonvested
shares have a grant-date fair-value-based measure of $50 per share and vest at the end of the fourth year
of service (i.e., cliff vesting). The average market price of C’s stock price for 20X1 is $60 per share. Holders
of nonvested shares have a nonforfeitable right to receive cash dividends on a 1:1 per-share basis with the
common shareholders. Accordingly, the nonvested shares are participating securities for which C must use the
two-class method in calculating basic and diluted EPS. In fiscal year 20X1, C declares and pays $2.5 million in
dividends for both the common shares and the nonvested shares.
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Because there are no potential common shares other than the participating nonvested shares, antidilution
sequencing is not required.
Calculation of diluted EPS for the common shares in which the use of the treasury stock method for the
participating nonvested shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Because C’s capital structure only includes common shares and the participating nonvested shares (i.e., there
are no other potential common shares), basic and diluted EPS under the two-class method would be the same
($4.00).
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, C would disclose an amount of diluted EPS per common share that would result from applying
the two-class method ($4.00) because that amount is more dilutive than the amount that would result from
applying the treasury stock method ($4.68). In accordance with ASC 260-10-45-60, C would be permitted, but
not required, to present basic and diluted EPS for the participating nonvested shares on the face of the income
statement. See further discussion in Section 9.1.4.
Example 5-24
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Nonvested Share-Based Payment Awards With Convertible Debt and Warrants
Assume that Entity D has 1 million weighted-average shares of common stock outstanding for the fiscal year
ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, D issues 250,000 nonvested share-based payment awards to its employees. The nonvested
shares have a grant-date fair-value-based measure of $50 per share and vest at the end of the fourth year
of service (i.e., cliff vesting). The average market price of D’s stock price for 20X1 is $60 per share. Holders
of nonvested shares have a nonforfeitable right to receive cash dividends on a 1:1 per-share basis with the
common shareholders. Accordingly, the nonvested shares are participating securities for which D must use the
two-class method in calculating basic and diluted EPS. In fiscal year 20X1, D declares and pays $2.5 million in
dividends for both the common shares and the nonvested shares.
In addition, assume the following:
- On January 1, 20X1, D issues warrants to purchase 100,000 shares of its common stock at $40 per share for a period of five years. The warrants do not meet the definition of a participating security.
- On January 1, 20X1, D issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of D’s common stock and bears an interest rate of 3 percent. The convertible bonds do not meet the definition of a participating security.
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
Note that this calculation is the same as the calculation of basic EPS in
Example 5-23, because basic EPS is not
affected by the warrants and convertible debt since
neither security is a participating security.
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Calculation of diluted EPS for the common shares in which the use of the treasury stock method for the participating
nonvested shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, D would use the two-class method to disclose diluted EPS per common share ($3.58) because
that amount is more dilutive than the amount that would result from applying the if-converted method ($4.18).
In accordance with ASC 260-10-45-60, D would be permitted, but not required, to present basic and diluted
EPS for the participating nonvested shares on the face of the income statement. See further discussion in
Section 9.1.4.
Footnotes
5
The allocation of undistributed losses is consistent
with the guidance in the MLP subsections of ASC 260 that addresses
the application of the two-class method to MLPs when distributions
exceed earnings. See further discussion in Section
8.9.3.
6
In this table, it is assumed
that the income or loss amounts are after the
allocation of any distributed earnings.
7
It would be highly unusual for securities that
participate only upon the occurrence of contingent events to
participate in losses.
8
If a security participates only in objectively
determinable and nondiscretionary dividends that meet the definition
of an extraordinary dividend, the amount of undistributed earnings
that would be assumed to be distributed will affect whether the
distribution of those earnings would qualify as an extraordinary
dividend.
9
Section 3.2.2
contains detailed discussion of what constitutes
dividends on preferred stock in the calculation of
income available to common stockholders. As
discussed in that section, dividends on preferred
stock include the accretion of dividends on
increasing-rate preferred stock, measurement
adjustments to reflect redeemable preferred stock at
its redemption amount under ASC 480-10-S99-3A, the
recognition of a down-round feature, and other
“deemed dividends” or “deemed contributions.”
Dividends on preferred stock that are treated as an
adjustment to net income to arrive at income
available to common stockholders represent
distributed earnings under the two-class method of
calculating EPS.
10
The entity-wide policy election related to the
treatment of forfeitures for employee awards can be made
separately from that for nonemployee awards.
11
All nonforfeitable dividends on share-based
payment awards that are classified as liabilities are recognized
in compensation expense.
12
The portion expected to vest
will be based on the revised estimated forfeitures
applicable to the current-period dividends. Thus,
distributed earnings for the period will equal the
amount of current-period dividends on unvested
participating share-based payment awards that are
recognized in retained earnings.
13
As discussed in Section 3.2.4.3.1, the
accounting for the common shares as being effectively retired is
an exception to the general requirement that outstanding common
shares must be included in the denominator for both basic and
diluted EPS.
14
If one class of common stock is redeemable at the
option of the holder, the entity should consider the terms of the
redemption and the application of the guidance in ASC 480-10-S99-3A
in the determination of how to allocate undistributed losses.
Chapter 6 — Convertible Debt
Chapter 6 — Convertible Debt
6.1 Background
This chapter, which supplements the discussion in Chapters 3 and 4, addresses considerations related to basic
and diluted EPS that apply to convertible debt instruments, including those with
embedded put and call options. In this chapter, it is assumed that the debt
instrument was not issued in a share-based payment arrangement.
As discussed in Section 4.4.1, ASC 260-10-20 defines a convertible security as “[a] security that is convertible into another security based on a conversion rate.” By definition, a convertible security may be converted into common shares or other securities of the issuer. This chapter only discusses convertible securities classified as liabilities that are convertible into the issuer’s common shares (also referred to as “convertible debt instruments”).
Convertible debt instruments that are discussed in this chapter include:
-
Convertible debt that must be settled in common stock (Section 6.2).
-
Convertible debt that may be settled in cash or common stock (Section 6.3).
-
Mandatorily convertible debt (Section 6.4).
-
Stock-settled debt (Section 6.5).
Other considerations that may be relevant to convertible debt instruments are discussed in Section 6.6. See also Section 4.4.3 for the implications related to diluted EPS when a debt instrument is only contingently convertible.
For a comprehensive discussion of the issuer’s accounting for convertible debt
instruments, see Section
7.6 of Deloitte’s Roadmap Issuer’s Accounting for Debt.
6.2 Convertible Debt That Must Be Settled in Common Stock
6.2.1 Background
This section discusses convertible debt instruments that have each of the
following characteristics:
-
Upon conversion, the issuer is required to deliver common shares to the holder (i.e., neither the issuer nor the holder can elect to have any portion of a conversion settled in cash).
-
The holder benefits from an appreciation in the fair value of the issuing entity’s common shares from the issuance date of the instrument, and the conversion feature is substantive.
-
The holder is not required to convert the security into common shares.
Such convertible debt instruments are also referred to as “traditional
convertible debt instruments.”
In some situations, the issuing entity is required to separate the embedded
conversion option from the host debt contract under ASC 815-15. In other
situations, the issuing entity accounts for the convertible debt instrument at
fair value through earnings. Unless otherwise noted, this section only addresses
traditional convertible debt instruments that are accounted for at amortized
cost in their entirety. Sections 6.6.3 and 6.6.4 address additional considerations
related to situations in which the issuing entity has separated the embedded
conversion option as a derivative instrument or has elected to account for the
convertible debt instrument at fair value through earnings.
6.2.2 Basic EPS
Provided that a traditional convertible debt instrument does not meet the definition of a participating security, the impact on basic EPS is attributable to (1) a reduction of the numerator (i.e., net income) resulting from the recognition of interest expense or an adjustment to the numerator resulting from the recognition of a gain or loss on extinguishment and (2) an increase in the denominator once the convertible debt instrument has been settled in exchange for common stock (i.e., an increase in the weighted-average common shares outstanding calculated from the date the security is exchanged for common stock). If a traditional convertible debt instrument meets the definition of a participating security, the entity must apply the two-class method to calculate basic EPS (see Chapter 5).
Interest expense consists of the stated interest coupon on the debt and the
amortization or accretion of any discount or premium. The table below describes
common types of discounts or premiums on traditional convertible debt
instruments and the general accounting requirements for recognizing interest
expense and settlements. This table is not intended to represent an exhaustive
list of the accounting guidance applicable to the subsequent measurement or
derecognition of traditional convertible debt instruments. It is only intended
to describe the impact that traditional convertible debt instruments commonly
have on the numerator in the calculation of basic EPS. In this table, it is
assumed that the conversion feature was substantive as of the issuance date.
Table 6-1
Character | Description | Accounting Treatment1 |
---|---|---|
Original issue discount or premium | A traditional convertible debt instrument may have an original issue discount or premium related to (1) an issuance for proceeds that differ from the principal amount, (2) an allocation of proceeds between the convertible debt instrument and other financial instruments, or (3) the recognition of the convertible debt instrument at fair value as a result of a modification or exchange involving the instrument that is accounted for as an extinguishment under ASC 470-50. Note that in this table, it is assumed that the embedded conversion option has
not been bifurcated from the convertible debt
instrument. See Section 12.4 of
Deloitte’s Roadmap Issuer’s Accounting for
Debt for discussion of the
accounting for a conversion of a convertible debt
instrument with a bifurcated conversion option. See
Section 3.2.6.5 for discussion of when
an embedded conversion option is reclassified from a
derivative liability to a component of stockholders’
equity. | The discount or premium is amortized to interest expense over the term of the
debt in accordance with the interest method, as
specified in ASC 835-30-35-2. Discounts on debt
instruments that are puttable upon the passage of time
at the option of the holder are amortized to the first
put date. Any unamortized discount or premium remaining as of the date on which a traditional convertible debt instrument is converted into common stock in accordance with its original conversion terms is subsumed into the carrying amount of the common stock in accordance with ASC 470-20-40-4, with no gain or loss recognized in earnings.
If a traditional convertible debt instrument is extinguished before maturity for cash or other assets, any unamortized discount or premium remaining on the date of extinguishment is recognized in earnings as an extinguishment gain or loss in accordance with ASC 470-50-40-2. |
Discount arising from a separately recognized equity component related to a modification or exchange involving the embedded conversion option that is not accounted for as an extinguishment | Under ASC 470-50-40-15, an entity must recognize an increase in the fair value
of an embedded conversion option resulting from a
modification or exchange that is not accounted for as an
extinguishment as a reduction of the carrying amount of
the debt instrument (an increase in a debt discount or a
reduction of a debt premium), with a corresponding
increase in APIC. | The discount or premium on a traditional convertible debt instrument after the
recognition of the increased fair value of the embedded
conversion option is amortized to interest expense over
the term of the debt in accordance with the interest
method, as specified in ASC 835-30-35-2. Discounts on
debt instruments that are puttable upon the passage of
time at the option of the holder are amortized to the
first put date. The Codification does not specifically address the accounting for any
unamortized discount remaining as of the date on which a
traditional convertible debt instrument is converted
into common stock in accordance with its original
conversion terms. Given the similarities with the
guidance in ASC 815-15-40-1,2 an entity should recognize any unamortized
discount remaining on the date of conversion immediately
as interest expense. The Codification does not specifically address the accounting for traditional
convertible debt instruments that are extinguished
before maturity for cash or other assets. Given the
similarities with the guidance in ASC 815-15- 40-4,3 an entity should allocate an amount of the
reacquisition price to the repurchased equity component.
Generally, this amount would equal the value that was
previously recognized for that separate equity
component. The remaining reacquisition price should be
allocated to the debt to determine the amount of gain or
loss on extinguishment. |
See Section 6.6.1 for a discussion of the impact of an induced conversion.
6.2.3 Diluted EPS
Provided that a traditional convertible debt instrument does not represent a
participating security, the if-converted method4 is used to reflect the impact of the embedded conversion option on diluted
EPS. Under the if-converted method, an entity must adjust both the numerator and
denominator. Since an entity using the if-converted method assumes that a
convertible debt instrument was converted into common shares at the beginning of
the reporting period (or the date of issuance, if later), the numerator is
adjusted to reverse any recognized interest expense (including any amortization
of discounts discussed in Table 6-1), net of tax.5 The common shares issuable upon conversion are added to the denominator on
the basis of the most favorable conversion terms available to the holder. Except
in the case of certain contingently convertible debt instruments, the
if-converted method, if dilutive, must be applied even if the embedded
conversion option is out-of-the-money. See Section 4.4 for further discussion of the
if-converted method. Section
4.9.3 discusses the application of the if-converted method to
year-to-date calculations of diluted EPS.
Footnotes
1
No specific adjustments are made
to the numerator in the calculation of basic EPS,
since interest expense is recognized in net
income.
2
ASC 815-15-40-1 addresses the accounting upon
conversion of a convertible debt instrument that
contains a discount as a result of a prior
reclassification of the embedded conversion option
from a derivative liability to stockholders’
equity.
3
ASC 815-15-40-4 addresses the accounting upon
redemption of a convertible debt instrument that
contains a discount as a result of a prior
reclassification of the embedded conversion option
from a derivative liability to stockholders’
equity.
4
If a traditional convertible debt instrument meets the
definition of a participating security, the issuing entity must apply
the more dilutive of the if-converted method or the two-class method to
calculate diluted EPS. See Section 5.5.4 for more
information.
5
An entity should not adjust the numerator to add the
amount of interest expense that would have been accelerated into
earnings as of the conversion date for a traditional convertible debt
instrument that contains a separately recognized equity component.
6.3 Convertible Debt That May Be Settled in Cash or Common Stock
6.3.1 Background
There are four types of convertible debt instruments whose stated conversion
terms require or allow the issuing entity to settle a conversion either
partially or entirely in cash. These four convertible debt instrument types are
as follows:6
-
Instrument A — Upon conversion, the issuer must satisfy the entire obligation in cash equivalent to the conversion value. The entire obligation comprises (1) the accreted value of the debt obligation plus (2) the conversion spread.
-
Instrument B — Upon conversion, the issuer may satisfy the entire obligation in either common stock or cash equivalent to the conversion value. The entire obligation comprises (1) the accreted value of the debt obligation plus (2) the conversion spread.
-
Instrument C — Upon conversion, the issuer must satisfy the accreted value of the debt obligation (the amount accrued to the benefit of the holder, excluding the conversion spread, or the principal amount of the debt) in cash and may satisfy the conversion spread in either common stock or cash.
-
Instrument X — Upon conversion, the issuer may satisfy the accreted value of the obligation (the amount accrued to the benefit of the holder, excluding the conversion spread, or the principal amount of the debt) in either cash or common stock and may satisfy the conversion spread in either common stock or cash (i.e., the issuer can pay any combination of cash or common stock to achieve conversion).
An issuing entity must either separate the embedded conversion option under ASC
815-15 or apply the fair value option to Instrument A (see Example 6-1). Unless the
embedded conversion option must be separated under ASC 815-15, Instruments B, C,
and X are accounted for in the same manner as traditional convertible debt
instruments. However, the EPS accounting considerations differ for Instrument C
convertible debt instruments.
The remaining discussion in Section 6.3 focuses on the considerations related to basic and
diluted EPS for Instruments B, C, and X (referred to collectively as “cash
convertible debt instruments”) when the issuing entity has not separated the
embedded conversion option under ASC 815-15 and has not elected to apply the
fair value option to such instruments. Sections 6.6.3 and 6.6.4 address
considerations related to situations in which the issuing entity has separated
the embedded conversion option under ASC 815-15 or has elected to apply the fair
value option to such instruments.
6.3.2 Basic EPS
Provided that a cash convertible debt instrument does not represent a
participating security, basic EPS is affected as a result of (1) a reduction of
the numerator (i.e., net income) due to the recognition of interest expense or
an adjustment to the numerator due to the recognition of a gain or loss on
extinguishment7 and (2) an increase in the denominator if the convertible debt instrument
has been settled in exchange for common stock (i.e., an increase in the
weighted-average common shares outstanding calculated from the date the security
is exchanged for common stock). If the cash convertible debt instrument meets
the definition of a participating security, the entity must apply the two-class
method to calculate basic EPS (see Chapter 5).
Modifications or exchanges involving cash convertible debt instruments may
affect the carrying amount of the instrument and the effective interest rate
used to amortize the discount between the carrying amount and principal amount
of the instrument. Thus, a modification or exchange could also affect the
numerator in the calculation of basic EPS. See Section 6.6.1 for a discussion of the
impact of an induced conversion.
6.3.3 Diluted EPS
6.3.3.1 General
ASC 260-10
Contracts
That May Be Settled in Stock or Cash
45-45 The effect of potential
share settlement shall be included in the diluted
EPS calculation (if the effect is more dilutive) for
an otherwise cash-settleable instrument that
contains a provision that requires or permits share
settlement (regardless of whether the election is at
the option of an entity or the holder, or the entity
has a history or policy of cash settlement). An
example of such a contract accounted for in
accordance with this paragraph and paragraph
260-10-45-46 is a written call option that gives the
holder a choice of settling in common stock or in
cash. An election to share settle an instrument, for
purposes of applying the guidance in this paragraph,
does not include circumstances in which share
settlement is contingent upon the occurrence of a
specified event or circumstance (such as
contingently issuable shares). In those
circumstances (other than if the contingency is an
entity’s own share price), the guidance on
contingently issuable shares should first be
applied, and, if the contingency would be considered
met, then the guidance in this paragraph should be
applied. Share-based payment arrangements that are
payable in common stock or in cash at the election
of either the entity or the grantee shall be
accounted for pursuant to this paragraph and
paragraph 260-10-45-46, unless the share-based
payment arrangement is classified as a liability
because of the requirements in paragraph
718-10-25-15 (see paragraph 260-10-45-45A for
guidance for those instruments). If the payment of
cash is required only upon the final liquidation of
an entity, then the entity shall include the effect
of potential share settlement in the diluted EPS
calculation until the liquidation occurs.
45-46 A contract that is
reported as an asset or liability for accounting
purposes may require an adjustment to the numerator
for any changes in income or loss that would result
if the contract had been reported as an equity
instrument for accounting purposes during the
period. That adjustment is similar to the
adjustments required for convertible debt in
paragraph 260-10-45-40(b).
Contracts
That May Be Settled in Stock or Cash
55-32 Adjustments shall be
made to the numerator for contracts that are asset
or liability classified, in accordance with Section
815-40-25, but for which the potential common shares
are included in the denominator in accordance with
the guidance in paragraph 260-10-45-45. For purposes
of computing diluted EPS, the adjustments to the
numerator are only permitted for instruments for
which the effect on net income (the numerator) is
different depending on whether the instrument is
accounted for as an equity instrument or as an asset
or liability (for example, those that are within the
scope of Subtopics 480-10 and 815-40).
A conversion of a cash convertible debt instrument in accordance with its
original conversion terms may be settled in cash, common stock, or a
combination thereof. Nevertheless, diluted EPS must always be calculated on
the basis of share settlement. This is the case regardless of whether the
issuer or the holder of the instrument can elect the form of settlement upon
a conversion.
6.3.3.1.1 Application of If-Converted Method to Cash Convertible Debt Instruments
An entity must apply the if-converted method to
Instruments B, C, and X on the basis of the conversion terms that are
most advantageous to the holder, as required by ASC 260-10-45-21. It is
not appropriate for the entity to calculate diluted EPS on the basis
that it will elect to cash-settle any portion of the cash convertible
debt instruments that may be settled in cash or common stock. See
Example
6-1 for an illustration of the accounting for diluted EPS
for Instrument A.
The application of the if-converted method of
calculating diluted EPS for Instrument C differs from that for
Instruments B and X. For Instruments B and X, the numerator is adjusted
to add back interest, net of tax, and the gross number of shares of
common stock issuable upon conversion is added to the denominator.
Because the principal amount of Instrument C must be settled in cash,
the numerator is not adjusted in the calculation of diluted EPS for this
instrument (see ASC 260-10-45-40(b)(1)). Rather, an entity uses the
if-converted method to calculate diluted EPS by determining the number
of shares needed to settle the conversion premium (i.e., the portion of
the convertible debt instrument in excess of the principal amount that
is settled in shares) and adding that amount to shares outstanding to
calculate the denominator for diluted EPS purposes. The average market
price is used to determine such dilution in accordance with ASC
260-10-45-21A. The effect would be dilutive if the average market price
of the shares exceeds the conversion price. However, if the average
market price of the shares was less than the conversion price, the
conversion premium would be zero and there would be no dilutive
effect.
See Section 4.4.3 for examples
illustrating the calculations of diluted EPS for Instruments C and X.
Connecting the Dots
Although ASC 260 refers to the calculation of
diluted EPS for an Instrument C convertible debt instrument
under the if-converted method, this calculation is the same as
that under the treasury stock method. Therefore, it is important
for an entity to determine whether it is appropriate to
calculate diluted EPS by using the approach that applies to an
Instrument C convertible debt instrument. For example, assume
that an entity issues a convertible debt instrument that becomes
convertible, at the holder’s option, upon the mere passage of
time (i.e., the conversion option is not contingently
exercisable). Upon conversion of the instrument, the issuer must
pay the principal amount in cash and may elect to settle the
conversion spread in either common stock or cash. However, if
the issuing entity’s common stock price exceeds 150 percent of
the conversion price, the issuer has the right to call the
convertible debt instrument for par (i.e., the issuer can force
the holder to convert the instrument when its stock price
exceeds 150 percent of the conversion price). Upon any
conversion that is triggered as a result of this call option,
the issuing entity has the right to settle the instrument in any
combination of common stock or cash in a manner similar to how
an Instrument X convertible instrument is settled. Diluted EPS
for this convertible instrument should not be calculated in a
manner similar to how an entity accounts for diluted EPS for an
Instrument C convertible debt instrument. Because a market price
trigger is ignored in the calculation of diluted EPS for a
convertible debt instrument (see Section 4.4.3), the
issuing entity must assume that it will obtain the right to
settle any conversion entirely in shares. Therefore, the entity
should account for diluted EPS in the same manner in which the
if-converted method is applied to an Instrument X convertible
debt instrument.
Sections 6.6.3 and 6.6.4 discuss considerations related to
situations in which an entity has issued Instrument B, C, or X and has
either separated the embedded conversion option under ASC 815-15 or has
applied the fair value option. See Section
4.9 for further discussion of the year-to-date
calculations of diluted EPS.
Connecting the Dots
ASC 260-10-55-84 through 55-84B appear to
indicate that in calculating year-to-date diluted EPS for
Instrument C, an entity should use its average share price for
the year. However, this approach would be inconsistent with the
statement in the example that “[t]he conversion premium should
be included in diluted earnings per share based on the
provisions of paragraphs 260-10-45-45 through 45-46 and
260-10-55-32 through 55-36A.” These paragraphs require an entity
to apply ASC 260-10-55-3, which states that in the calculation
of year-to-date diluted EPS, “the number of incremental shares
to be included in the denominator shall be determined by
computing a year-to-date weighted average of the number of
incremental shares included in each quarterly diluted EPS
computation.” Therefore, despite what ASC 260-10-55-84 through
55-84B appear to say, an entity should determine year-to-date
diluted EPS for a convertible debt instrument that requires the
issuer to pay the principal amount in cash by calculating a
year-to-date average of the number of incremental shares
included in each calculation of quarterly diluted EPS. Such an
approach is consistent with the treasury stock method.
Footnotes
6
The names of the instruments are based on how they are
commonly referred to in practice. For all four instruments, the
“conversion spread” means (1) the number of common shares receivable on
conversion according to the original conversion terms multiplied by the
issuing entity’s common stock price less (2) the accreted value.
7
Because these items are recorded in net income, no specific adjustments
should be made to the numerator in the calculation of basic EPS.
6.4 Mandatorily Convertible Debt
6.4.1 Background
An entity may issue a debt instrument that is mandatorily convertible into common stock. The conversion may occur on a fixed maturity date or upon the occurrence of an event that is certain to occur. Although the instrument will be converted into common stock, it is still classified as a liability instrument.
6.4.2 Basic EPS
Although conversion into common shares will occur upon the mere passage of time, the common shares issuable upon conversion should not be included in the denominator in the calculation of basic EPS. If the convertible debt instrument is a participating security, the two-class method should be applied to calculate basic EPS (see Chapter 5). If the two-class method is not applied, no adjustments should be made to the numerator or denominator (i.e., the impact on basic EPS will result from the reduction in net income for interest expense recognized on the instrument). It is inappropriate to apply the if-converted method to calculate basic EPS.
6.4.3 Diluted EPS
An entity should apply the if-converted method to determine the dilutive effect
of a debt instrument that is mandatorily convertible into common shares (or the
more dilutive of the if-converted or the two-class method of calculating diluted
EPS if the instrument is a participating security). In applying the if-converted
method, an entity should calculate the dilutive impact on the basis of the
conversion terms that are most advantageous to the holder, as required by ASC
260-10-45-21. Furthermore, an entity must assume conversion into shares even if
the entity or holder could elect to have the instrument partially or fully
settled in cash.
6.5 Stock-Settled Debt
A financial instrument issued in the form of debt or equity that embodies an
unconditional obligation that the issuing entity must settle by issuing a variable
number of common shares equal to a fixed monetary amount must be classified as a
liability under ASC 480-10-25-14 and is often referred to as “stock-settled debt.”
Although a stock-settled debt instrument does not provide the holder with any
potential “upside” from increases in the issuing entity’s common stock, it meets the
definition of a convertible security; therefore, the if-converted method of
calculating diluted EPS must be applied to such an instrument. In applying the
if-converted method, an entity should include in the denominator the number of
common shares that would be issuable to settle the instrument on the basis of the
conversion terms that are most advantageous to the holder, as required by ASC
260-10-45-21.
If the issuing entity or the holder has the option of settling such a debt
instrument in either cash or a variable number of
common shares of an equivalent value, the issuing
entity must also apply the if-converted method,
because an entity cannot overcome the presumption
of share settlement. See Example
4-13 for an illustration of
stock-settled debt.
6.6 Other Considerations
6.6.1 Induced Conversions of Convertible Debt
6.6.1.1 Basic EPS
ASC 470-20-40 contains specific guidance on recognizing an induced conversion of
a convertible debt instrument. Under this guidance, an entity must recognize a loss
equal to the fair value of all securities and other consideration transferred in the
transaction in excess of the fair value of the consideration issuable in accordance with
the original conversion terms. In recognizing an inducement, an entity will not be
required to adjust the calculation of basic EPS because the loss on inducement will
already be reflected in the numerator. For additional discussion of induced conversion
accounting, see Section
12.3.4 of Deloitte’s Roadmap Issuer’s Accounting for Debt.
6.6.1.2 Diluted EPS
In the calculation of diluted EPS under the if-converted method, a recognized inducement loss should be added back to the numerator. By analogy to the guidance in ASC 260-10-S99-2, when an SEC registrant effects an induced conversion of only a portion of a class of outstanding convertible debt instruments, the entity should, in determining whether the if-converted method is dilutive for a financial reporting period, consider the convertible debt instruments converted in accordance with an inducement offer separately from other convertible debt instruments of the same class that are not converted under such an offer.
Connecting the Dots
When convertible debt instruments are converted during a financial reporting period in accordance with an inducement offer, an entity that is using the if-converted method assumes that the instruments were converted at the beginning of the reporting period, or on the date of issuance if later, on the basis of the stated conversion terms. Because the numerator adjustment will reflect a reversal of the additional consideration provided under the inducement offer, the application of the if-converted method during a period in which an induced conversion has occurred will typically be antidilutive for the convertible debt instruments that were converted under such an offer.
In the calculation of diluted EPS for an Instrument C convertible debt
instrument, any recognized inducement loss should not be added back to (reversed from)
the numerator.
6.6.2 Nonsubstantive Conversion Options
ASC 470-20-40-5 addresses the accounting for an issuance of common shares “to settle a debt instrument (pursuant to the instrument’s original conversion terms) that became convertible [only upon the issuing entity’s] exercise of a call option.” According to this guidance, the issuing entity must evaluate whether the debt instrument contained a substantive conversion feature as of its issuance date. If the debt instrument did not contain a substantive conversion feature as of its issuance date, any settlement through the issuance of common stock should not be treated as a conversion for accounting purposes but should be accounted for as a debt extinguishment, with a gain or loss recognized in earnings (i.e., the fair value of the common shares issued would equal the reacquisition price that is compared with the carrying amount to determine the gain or loss on extinguishment).
Although it is not common for debt instruments to contain nonsubstantive
embedded conversion features, if such a feature exists and it can be exercised by the
holder only if the issuing entity exercises an option to call the
debt before its maturity, the entity is not required to apply the if-converted method to
calculate diluted EPS in all financial reporting periods. Rather, since the entity
controls the ability to avoid issuing common shares by virtue of its right not to exercise
the call option, the entity should, in considering the implications related to diluted
EPS, if any, take into account the fact that it controls exercise of the call option. If,
however, the holder of a debt instrument has the right to exercise a conversion feature
that is considered nonsubstantive as of the issuance date, the entity should evaluate the
conversion feature as an embedded put option. The same accounting would apply if the
conversion feature only became substantive after the issuance date. In both circumstances,
the put option is treated in the same manner as stock-settled debt and the if-converted
method applies, as discussed in Section
6.5.
6.6.3 Embedded Conversion Option Is Separated Under ASC 815-15
An entity may be required to separate the embedded conversion option in a
convertible debt instrument under ASC 815-15 and account for the embedded conversion
option at fair value through earnings. Separately accounting for the embedded conversion
option as a derivative liability does not obviate the need to include the dilutive effect
of the instrument under ASC 260 by using the if-converted method unless the issuing entity
is always required to settle a conversion entirely in cash (see Example 6-1 below). When the embedded conversion option is accounted for as
a derivative liability, with changes in fair value recognized in earnings, in addition to
other adjustments to the numerator (e.g., to add back interest expense), the
mark-to-market adjustment recognized in earnings during the financial reporting period
must be reversed and treated as an adjustment to the numerator in accordance with ASC
260-10-55-36A, provided that an entity determines that the combined effect of the
numerator and denominator adjustments is dilutive after considering the antidilution
sequencing requirements of ASC 260. When the if-converted method is not dilutive, an
entity does not adjust the numerator or denominator in calculating diluted EPS.
Example 6-1
Implications Related to Diluted EPS for Instrument A
Company D issued convertible debt in the form of Instrument A. Upon conversion, D must satisfy the entire obligation in cash equivalent to the conversion value; therefore, D has separated the embedded conversion option as a derivative under ASC 815-15.
The if-converted method does not apply because settlement of the convertible debt instrument will not result in the issuance of any common stock. For Instrument A, no adjustments are required in the calculation of diluted EPS because the embedded conversion option does not meet the definition of potential common stock in ASC 260-10-20. Therefore, the numerator should not be adjusted for either (1) the mark-to-market adjustment recognized in earnings as a result of changes in the fair value of the embedded conversion option or (2) any interest expense recognized in earnings. Further, there is no incremental impact on the denominator in the calculation of diluted EPS. The same conclusion would apply if D had elected the fair value option.
See Section 3.2.6.5
for discussion of when an embedded conversion option is reclassified from a derivative
liability to a component of stockholders’ equity.
6.6.4 Convertible Debt Instrument Recognized at Fair Value
ASC 825 allows an entity to elect, on initial recognition, the fair value option for convertible debt instruments that do not contain any component that must be classified in stockholders’ equity (see ASC 825-10-15-5(f)). Entities may elect the fair value option in lieu of separating an embedded conversion option that would otherwise need to be accounted for separately under ASC 815-15.
Accounting for a convertible debt instrument at fair value does not obviate the
need to include the dilutive effect of the instrument under ASC 260 by using the
if-converted method unless the issuing entity is always required to settle a conversion
entirely in cash (see Example 6-1). When a
convertible debt instrument is accounted for at fair value, the mark-to-market adjustment
recognized in earnings during the financial reporting period must be reversed and treated
as an adjustment to the numerator in accordance with ASC 260-10-55-36A, provided that an
entity determines that the combined effect of the numerator and denominator adjustments is
dilutive after considering the antidilution sequencing requirements of ASC 260. When the
if-converted method is not dilutive, an entity does not adjust the numerator or
denominator in calculating diluted EPS.
Connecting the Dots
ASC 825-10-45-5 requires entities to “present separately in other comprehensive income the portion of the total change in the fair value” of a financial liability that is recognized at fair value through earnings that results from the change in instrument-specific credit risk. Since the credit component does not enter into the determination of net income, it should be excluded from any adjustment made to the numerator in the calculation of diluted EPS. This credit component would only be included in the adjustment to the numerator if the entity presented comprehensive income per share.
6.6.5 Put and Call Options Embedded in Debt Instruments
6.6.5.1 Background
Convertible debt instruments may contain contractual terms that allow the holder
or issuing entity to require early redemption at a fixed or determinable amount. An
entity must analyze such embedded put and call options under ASC 815-15 to determine
whether they must be separated from the host debt contract and accounted for as a
derivative instrument. If such embedded put and call options can or must be settled in
common shares, the entity must also consider the implications related to diluted EPS.
While this chapter focuses on convertible debt instruments, the sections below include
discussion of redemption features in nonconvertible debt instruments.
6.6.5.2 Embedded Put Options
The table below summarizes considerations related to calculating diluted EPS for
a nonconvertible debt instrument that contains an embedded put option that
allows the counterparty to redeem the debt at a fixed or determinable amount
either as of the reporting date or upon the mere passage of time. If the
embedded put option is contingently exercisable by the counterparty, the
entity should apply the guidance in this table if the embedded put option is
or would be exercisable, provided that the conditions as of the reporting
date remain unchanged in accordance with the contingently issuable share
method of calculating diluted EPS (see Section 4.5). The accounting
implications for convertible debt instruments that contain an embedded put
option are discussed below this table.
Table 6-3
Form of Consideration on Settlement(a) | Party That Elects Settlement Form | Accounting Classification of Embedded Put Option | Assumed Settlement for EPS Purposes | Accounting for Diluted EPS |
---|---|---|---|---|
Cash | N/A | Not separated from host contract | Cash | No adjustment(b) |
Common stock | N/A | Not separated from host contract | Shares | If-converted method(c) |
Cash or common stock | Issuing entity | Not separated from host contract |
Shares |
If-converted method(c) |
Cash or common stock | Holder | Not separated from host contract | Shares | If-converted method(c) |
Cash | N/A | Separated as embedded derivative | Cash | No adjustment(b) |
Common stock | N/A | Separated as embedded derivative | Shares | If-converted method(d) |
Cash or common stock | Issuing entity | Separated as embedded derivative |
Shares |
If-converted method(d) |
Cash or common stock | Holder | Separated as embedded derivative | Shares | If-converted method(d) |
Notes to Table: (a) It is assumed that the monetary amount paid on settlement is the same,
regardless of whether the settlement is in cash or
common stock. (b) The embedded put option does not meet the definition of potential common
stock in ASC 260-10-20. (c) Application of the if-converted method is consistent with the diluted EPS
accounting for stock-settled debt (see Section
6.5). (d) In applying the if-converted method, an entity must adjust the numerator to
remove the mark-to-market effect on net income during the financial
reporting period from recognizing the embedded derivative at fair value,
since no fair value amount would have been recognized if the put option had
been settled at the beginning of the financial reporting period (or the date
of issuance, if later). |
ASC 260-10-45-21 must be considered for debt instruments that contain an
embedded put option and a substantive embedded conversion option. ASC 260-10-45-21
states that diluted EPS “shall be based on the most advantageous conversion rate or
exercise price from the standpoint of the security holder.” If a convertible debt
instrument contains a substantive embedded conversion option and an embedded put option
that the issuing entity must or may settle in common shares, in each financial reporting
period, the issuing entity must consider whether it is more advantageous for the
security holder to elect to exercise the embedded conversion option or the embedded put
option. If it is more advantageous for the security holder to exercise the embedded
conversion option, the impact of the convertible instrument on diluted EPS should be
determined by applying the if-converted method on the basis of the terms of the
conversion feature, if dilutive. Otherwise, the impact on diluted EPS should be
determined on the basis of the guidance in the table above (i.e., by applying the
if-converted method to the put option). The impact on diluted EPS will generally reflect
the more dilutive of the two alternatives because the number of common shares that is
assumed to be issued will generally be the greater of the number of common shares
issuable in accordance with the terms of the (1) put option or (2) conversion
option.
In applying the more dilutive impact of settlement of a convertible debt
instrument under a conversion option or a put option, an entity may also need to adjust
the numerator in accordance with ASC 260-10-55-36A. This adjustment may pertain to the
embedded option that is not assumed to be settled in shares for diluted EPS. For
example, assume that an entity that has issued a convertible debt instrument that is not
in the form of Instrument C has determined that applying the if-converted method to the
embedded conversion option is more advantageous to the holder than determining dilution
on the basis of an assumed settlement of the embedded put option. Furthermore, assume
that the embedded conversion option has not been separated as an embedded derivative
under ASC 815-15 but the embedded put option has been separated as an embedded
derivative. In this case, the calculation of diluted EPS under the if-converted method
would also include an adjustment to the numerator to reverse the fair value amounts that
affected net income as a result of marking to market the put option derivative
liability. However, the entity’s calculation of diluted EPS would include these
adjustments (i.e., the numerator adjustments related to applying the if-converted method
and reversing the mark-to-market impact of the embedded put option and the denominator
adjustment for the potential common shares issuable under the conversion option) only if
the entity finds them to be dilutive after considering the antidilution sequencing
requirements of ASC 260. This requirement applies regardless of whether the put option
must or may be settled in cash or shares. However, if the embedded put option allows for
settlement in shares and the effect of the if-converted method on the basis of an
assumed share settlement of the embedded conversion option is antidilutive, the entity
should determine whether the application of the if-converted method to the put option is
dilutive.
Connecting the Dots
As discussed in Section 6.3.3.1.1, the calculation of diluted EPS under the
if-converted method for an Instrument C convertible debt instrument is akin to the
treasury stock method. Therefore, if a cash-settled embedded put option is separated
as an embedded derivative, the numerator should not be adjusted to reverse the
income statement effect of accounting for the embedded put option as a derivative
liability, because the embedded put option pertains to the extinguishment of the
host debt instrument and would be cash-settled. That is, ASC 260 prohibits an entity
from making this adjustment to the numerator when applying the if-converted method
to an Instrument C convertible debt instrument.
6.6.5.3 Embedded Call Options
Embedded call options that allow the issuing entity to redeem nonconvertible or convertible debt instruments that are not separated as embedded derivative instruments under ASC 815-15 will generally have no incremental impact on the calculation of diluted EPS. Regardless of whether an embedded call option, when exercised, may or must be settled in common shares, the call option generally does not affect the calculation of diluted EPS because it does not meet the definition of potential common stock in ASC 260-10-20. As defined, potential common stock represents “[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.” An embedded call option does not entitle its holder, which is the issuing entity, to obtain common stock.
If, however, an entity has separated an embedded call option as a derivative
instrument under ASC 815-15 and is applying the if-converted method to calculate diluted
EPS, it must adjust the numerator to reverse the mark-to-market impact related to
separating this embedded derivative liability if an entity determines that the combined
effect of the numerator and denominator adjustments under the if-converted method is
dilutive after considering the antidilution sequencing requirements of ASC 260. However,
no such adjustment should be made to the numerator if the if-converted method is applied
to reflect the dilution of the embedded conversion option in an Instrument C convertible
debt instrument, since the embedded call option pertains to the extinguishment of the
host debt instrument.
Chapter 7 — Share-Based Payment Awards and Other Compensation Arrangements
Chapter 7 — Share-Based Payment Awards and Other Compensation Arrangements
7.1 Share-Based Payment Awards
ASC 718-10
Earnings per Share
45-1 Topic 260 requires that equity
share options, nonvested shares, and similar equity
instruments granted under share-based payment transactions
be treated as potential common shares in computing diluted
earnings per share (EPS). Diluted EPS shall be based on the
actual number of options or shares granted and not yet
forfeited regardless of the entity’s accounting policy for
forfeitures in accordance with paragraphs 718-10-35-1D and
718-10-35-3, unless doing so would be antidilutive. If
vesting in or the ability to exercise (or retain) an award
is contingent on a performance or market condition, such as
the level of future earnings, the shares or share options
shall be treated as contingently issuable shares in
accordance with paragraphs 260-10-45-48 through 45-57. If
equity share options or other equity instruments are
outstanding for only part of a period, the shares issuable
shall be weighted to reflect the portion of the period
during which the equity instruments are outstanding.
45-2 Paragraphs 260-10-45-29
through 45-34 and Example 8 (see paragraph 260-10-55-68)
provide guidance on applying the treasury stock method for
equity instruments granted in share-based payment
transactions in determining diluted EPS.
This section supplements the discussion in Chapters 3, 4, and 5 to address specific considerations related to the calculation of basic and diluted EPS for share-based payment awards.
In calculating EPS, an entity should consider how a share-based payment award
may affect (1) income available to common stockholders (i.e., the numerator in the
EPS calculation) and (2) the weighted-average number of common shares or dilutive
potential common shares (i.e., the denominator in the EPS calculation). Because an
entity recognizes the fair-value-based measure of an award as compensation cost (or
as a reduction of revenue) in arriving at the entity’s income available to common
stockholders, awards granted in return for goods or services or as consideration
payable to a customer will typically affect the EPS numerator.
7.1.1 Basic EPS
During the requisite service period or nonemployee’s vesting period, share-based
payment awards do not affect the calculation of basic EPS (other than the effect
of the cost as a reduction of income available to common stockholders) unless
the awards are participating securities. An entity must apply the two-class
method when calculating basic and diluted EPS for such awards (see Section 7.1.3).
Once the good has been delivered, the service has been rendered, or the customer
has purchased goods or services from the entity, vested awards that are
considered outstanding common shares affect the denominator in the calculation
of basic EPS. That is, such awards will be included in the weighted-average
number of common shares from the date on which they become vested outstanding
common shares. If the awards do not become outstanding common shares during the
period and are not considered participating securities, they generally are not
included in the calculation of basic EPS. However, contingently issuable shares
should be included in the denominator of basic EPS when there are no
circumstances in which those shares would not be issued (see Section 3.3.2.5 for more
information).
Connecting the Dots
Employee awards of shares that vest when the grantee becomes eligible for
retirement must be considered outstanding shares in the denominator of
basic EPS as of the date on which the grantee is eligible to retire and
retain the shares. This is because, once the employee is eligible to
retire, there are no conditions that must be met for the common stock to
be issued. Such shares are not considered contingently issuable shares
since an agreement that requires an entity to issue common shares only
after the mere passage of time is not considered a contingently issuable
share arrangement. In other words, no remaining service period is
associated with the issuance of the shares since the holder can retire
at any time and receive the shares.
Share-based payment awards often contain clawback features. ASC 718-10-30-24,
ASC 718-20-35-2, and ASC 718-10-55-8 address the impact of clawback features.
30-24 A contingent feature of an
award that might cause a grantee to return to the entity either equity
instruments earned or realized gains from the sale of equity instruments
earned for consideration that is less than fair value on the date of
transfer (including no consideration), such as a clawback feature (see
paragraph 718-10-55-8), shall not be reflected in estimating the
grant-date fair value of an equity instrument.
35-2 A contingent feature of an
award that might cause a grantee to return to the entity either equity
instruments earned or realized gains from the sale of equity instruments
earned for consideration that is less than fair value on the date of
transfer (including no consideration), such as a clawback feature (see
paragraph 718-10-55-8), shall be accounted for if and when the
contingent event occurs. Example 10 (see paragraph 718-20-55-84)
provides an illustration of an employee award with a clawback
feature.
55-8 Reload features and
contingent features that require a grantee to transfer equity shares
earned, or realized gains from the sale of equity instruments earned, to
the issuing entity for consideration that is less than fair value on the
date of transfer (including no consideration), such as a clawback
feature, shall not be reflected in the grant-date fair value of an
equity award. Those features are accounted for if and when a reload
grant or contingent event occurs. A clawback feature can take various
forms but often functions as a noncompete mechanism. For example, an
employee that terminates the employment relationship and begins to work
for a competitor is required to transfer to the issuing entity (former
employer) equity shares granted and earned in a share-based payment
transaction.
Clawback features, as contemplated in ASC 718, are protective provisions that require or permit the recovery of value transferred to award holders who violate certain conditions. Examples include the violation of a noncompete or nonsolicitation agreement, termination of employment for cause (e.g., because of fraud or noncompliance with company policies), and material restatements of financial statements. ASC 718 requires that the effect of a clawback feature be accounted for only when the contingent event that triggers the clawback occurs. In a manner consistent with this guidance, vested common shares issued in a share-based payment should be considered outstanding shares in the calculation of basic EPS from the date vesting is complete. It would not be appropriate to exclude such common shares from the denominator of the calculation of basic EPS on the basis of the guidance in ASC 260 on contingently issuable (returnable) shares. This conclusion is consistent with paragraph 92 of the Background Information and Basis for Conclusions of Statement 128, which indicates that
vested shares for which the consideration has been received should be included
in the calculation of basic EPS. It is also consistent with informal discussions
with the FASB staff.
7.1.2 Diluted EPS
While share-based payment awards generally do not affect the calculation of
basic EPS (other than the effect of the cost as a reduction of income available
to common stockholders) during the requisite service period or nonemployee’s
vesting period (unless the award is a participating security), an entity
generally includes them in the denominator when calculating diluted EPS if the
effect is dilutive on the basis of the antidilution sequencing requirements of
ASC 260 (see Section
4.1.2 for more information). Further, awards (e.g., stock options
or warrants) that do not become outstanding common shares when the good is
delivered or the service is rendered, and that are not considered participating
securities, are not included in the calculation of basic EPS but may be included
in the denominator of diluted EPS before they are settled (e.g., are exercised,
are canceled, or expire).
An entity may change the terms or conditions of a share-based
payment award. ASC 718-20-35-3 states, in part, that “[e]xcept as described in
[ASC] 718-20-35-2A, a modification of the terms or conditions of an equity award
shall be treated as an exchange of the original award for a new award.” ASC
718-30-35-5 contains similar guidance for liability-classified awards and
states, in part, that “[a] modification of a liability award is accounted for as
the exchange of the original award for a new award.” In accordance with this
guidance, a modification of a share-based payment award that is not subject to
the exception in ASC 718-20-35-2A is treated as a cancellation of the existing
award and the issuance of a new award. In a manner consistent with the guidance
in ASC 718, an entity should treat the original and modified awards as two
separate awards in calculating diluted EPS. Thus, when the treasury stock method
applies to a modified share-based payment award, an entity would perform the
following two treasury stock method calculations:
- Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period before the modification (weighted, as appropriate, for the period).
- Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period after the modification (weighted, as appropriate, for the period).
The sum of these two calculations will equal the incremental common shares that
are included in the calculation of diluted EPS for the period.
ASC 718-20-35-2A addresses situations in which an entity
modifies a share-based payment award but is not required to apply modification
accounting. Entities will need to consider the specific facts and circumstances
associated with such types of modifications to determine whether they should be
treated as a single award or two separate awards in the calculation of diluted
EPS in the period that includes the change to the terms or conditions of the
award.
7.1.2.1 Treasury Stock Method
Section 4.2
addresses the application of the treasury stock method of calculating
diluted EPS. An entity generally includes the dilutive effect of share-based
payment awards (e.g., restricted stock, stock options) in the denominator of
the calculation of diluted EPS by applying the treasury stock method, under
which it is assumed that any service condition will be met. When applying
the treasury stock method to a stock option, the entity assumes that two
hypothetical transactions have occurred. The first is the hypothetical
exercise of the award (or, for a restricted stock award, the hypothetical
vesting of the award); the second is the hypothetical repurchase of shares
at the average market price during the period by using the assumed proceeds
that will be generated from the hypothetical exercise of the award (or, for
a restricted stock award, the hypothetical vesting of the award). The
incremental shares that would be hypothetically issued are the number of
shares assumed to be issued upon exercise of the award (or, for a restricted
stock award, the vesting of the award) in excess of the number of shares
assumed to be repurchased with the assumed proceeds. The incremental shares
are included in the number of diluted potential common shares as a component
of the denominator in the calculation of diluted EPS.
While the treasury stock method applies to both vested and unvested stock
options, as discussed in Section 4.2.2.1, it is used for such awards only when the
average market price of the entity’s common stock during the period exceeds
the exercise price of the awards (i.e., the award is in the money) on an
award-by-award basis. Thus, an entity needs to perform a separate treasury
stock method calculation for each individual in-the-money award. An entity
may perform the same calculation for awards that are granted to employees on
the same day with the same terms and conditions (the awards would presumably
have the same grant-date fair-value-based measure). Out-of-the-money awards
are considered antidilutive and excluded from the denominator in the
calculation of diluted EPS. The determination of whether an award is
in-the-money or out-of-the-money is made on an individual award basis. See
Section 4.2
for further discussion of the application of the treasury stock method.
7.1.2.1.1 Assumed Proceeds
ASC 260-10-45-29 and 45-29A discuss the proceeds that are assumed under the
treasury stock method. When determining the amount of assumed proceeds
that a share-based payment award will generate, an entity aggregates (1)
the exercise price of the award, if any, and (2) the average amount of
cost attributed to share-based payment awards not yet recognized.1 Because there is no exercise price for restricted stock awards,
the entity includes in the assumed proceeds only the average amount of
cost not yet recognized.
7.1.2.1.2 Period Outstanding
An entity must consider the amount of time a share-based payment award was
outstanding during the reporting period. If an award was outstanding for
the entire reporting period, the incremental shares determined under the
treasury stock method are included in the calculation of diluted EPS for
the entire reporting period. By contrast, if an award was issued,
exercised (or, for a restricted stock award, becomes vested), or
forfeited during the reporting period, the incremental shares are
included only for the period in which the award was outstanding when the
treasury stock method is applied. Once the award is exercised (or, for a
restricted stock award, becomes vested), the shares issued are
considered outstanding common shares and are included in the
weighted-average number of common shares outstanding (i.e., the
denominator in the calculations of basic and diluted EPS). See further
discussion in Section
4.2.2.1.3.1.
7.1.2.1.3 Quarter-to-Date Versus Year-to-Date Calculations
When applying the treasury stock method to a quarterly period, an entity should
use the average market price for the period to determine the number of
incremental shares to include in the denominator of the calculation of
diluted EPS. That is, the entity computes the number of incremental
shares for the quarterly period as though that period is a discrete
period. By contrast, in accordance with ASC 260-10-55-3, in the
denominator of the calculation of diluted EPS for the year-to-date
period, an entity includes a weighted-average number of incremental
shares for each of the quarterly periods. The average market price for
the year-to-date period is not used as though the year-to-date period
was a separate discrete period. Example 1 in ASC 260-10-55-38 through
55-50 (excerpted in Section 4.10) and Example 12 in ASC 260-10-55-85 through
55-87 (excerpted in Section 4.9.1.1) illustrate quarter-to-date and
year-to-date EPS calculations. See Section 4.9.1 for further
discussion of the calculation of year-to-date EPS under the treasury
stock method.
7.1.2.1.4 Forfeitures
ASC 718 allows an entity to make an entity-wide accounting policy election to
either (1) estimate the number of awards that are expected to vest or
(2) account for forfeitures when they occur. The entity’s election will
affect the amount of compensation cost included in income available to
common stockholders (the numerator in the calculation of diluted EPS).
However, regardless of the entity’s policy election, the denominator in
the calculation of diluted EPS is based on the actual number of awards outstanding (i.e., the number of awards
is reduced only for actual forfeitures) in a given reporting period
provided that the effect is dilutive. Once an entity has determined the
number of outstanding awards that will have a dilutive effect on the
calculation of diluted EPS, the entity uses the treasury stock method to
determine the number of incremental shares to include in the denominator
of the calculation of diluted EPS.
For example, an entity that elects to estimate forfeitures may determine that
only 90 percent of the share-based payment awards issued to grantees are
expected to eventually vest even though none have actually been
forfeited yet. Accordingly, only 90 percent of the awards’
fair-value-based measure is recognized as compensation cost over the
requisite service period or nonemployee’s vesting period. However, when
determining the number of incremental shares to include in the
denominator of the calculation of diluted EPS, an entity must assume
that all outstanding dilutive awards that
contain only a service condition will vest or become exercisable.
Therefore, when calculating diluted EPS, the entity must (1) determine
the number of all outstanding awards that are dilutive and (2) apply the
treasury stock method.
When the treasury stock method is applied, the assumed proceeds are also
calculated on the basis of the actual number of all outstanding dilutive awards regardless of the entity’s
forfeiture policy election or whether certain of those awards are not
expected to eventually vest. The amount of average unrecognized cost is
therefore based on the total number of outstanding dilutive awards at
the beginning of the period and at the end of the period.
7.1.2.1.5 Treasury Stock Method Examples
The following examples illustrate the application of the treasury stock method
to share-based payment awards in the calculation of diluted EPS:
ASC 260-10
Example 8: Application of the Treasury Stock Method to a Share-Based Payment Arrangement
55-68 This Example illustrates the guidance in paragraph 260-10-45-28A for the application of the treasury stock method when share options are forfeited.
55-69 Entity A adopted a
share option plan on January 1, 20X7, and granted
900,000 at-the-money share options with an
exercise price of $30. All share options vest at
the end of three years (cliff vesting). Entity A’s
accounting policy is to estimate the number of
forfeitures expected to occur in accordance with
paragraph 718-10-35-1D or 718-10-35-3. At the
grant date, Entity A assumes an annual forfeiture
rate of 3 percent and therefore expects to receive
the service for 821,406 [900,000 × (.97 to the
third power)] share options. On January 1, 20X7,
the fair value of each share option granted is
$14.69. Grantees forfeited 15,000 stock options
ratably during 20X7.
55-69A The average stock price during 20X7 is $44. Net income for the period is $97,385,602. For the year ended December 31, 20X7, there are 25,000,000 weighted-average common shares outstanding. This guidance also applies if the service inception date precedes the grant date.
55-70 The following table illustrates computation of basic and diluted EPS for the year ended December 31, 20X7.
Example 7-1
Employee Stock Options — No Exercises or Forfeitures During the Period
Assume the following:
- Entity A has net income of $5 million, as well as 1 million common shares outstanding, for the year ended December 31, 20X2.
- As of December 31, 20X2, A also has 100,000 employee stock options outstanding. All the stock options were granted on January 1, 20X1, and vest solely on the basis of a two-year service condition. On December 31, 20X1, 50,000 stock options vested. The remaining 50,000 stock options vest on December 31, 20X2. All options are still outstanding on December 31, 20X2 (i.e., none have been exercised).
- All the stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
- Entity A recognizes compensation cost for these stock options on a straight-line basis over the service period from January 1, 20X1, to December 31, 20X2.
- The average market price of A’s common stock for the year ended December 31, 20X2, was $15 per share.
Entity A calculates diluted EPS for the year ended December 31, 20X2, as
follows:
The above calculation of diluted EPS is simplified since it is presented
annually without consideration of diluted EPS
amounts reported in A’s interim financial
statements. ASC 260-10-55-3 states, in part, “For
year-to-date diluted EPS, the number of
incremental shares to be included in the
denominator shall be determined by computing a
year-to-date weighted average of the number of
incremental shares included in each quarterly
diluted EPS computation.” Therefore, in an actual
calculation of year-to-date diluted EPS, an entity
must include the weighted-average incremental
shares on the basis of the amounts calculated for
interim periods (i.e., quarterly financial
reporting periods). For example, assume that when
applying the treasury stock method, A determined
that it must include 10,000 and 15,000 incremental
shares in the denominator of the calculation of
diluted EPS for its first and second quarter,
respectively. When calculating the number of
incremental shares to include in the denominator
for the year-to-date six-month period, A would
assign equal weight to the 10,000 and 15,000
incremental shares. Therefore, 12,500 incremental
shares [(10,000 + 15,000) ÷ 2] are included in the
denominator of the calculation of diluted EPS for
the year-to-date six-month period. See Sections
4.9.1 and 4.9.6 for more
information.
The example below illustrates the application of the treasury stock method to
stock option awards when a portion of the awards was exercised during
the period. Once the awards are exercised, the shares issued are
considered outstanding common shares and are included in the
weighted-average number of common shares outstanding (i.e., the
denominator in the calculation of basic EPS).
Example 7-2
Employee Stock Options — Exercises During the Period
Assume the same facts as in the example above, except that the 50,000 employee
stock options that vested on December 31, 20X1,
were exercised on June 30, 20X2.
Entity A calculates diluted EPS as follows:
As noted in Example
7-1, the above calculation of diluted
EPS is a simplified annual computation that does
not take into account interim calculations of
diluted EPS as required by ASC 260-10-55-3. The
above calculation is further simplified because of
how exercises during the period are factored into
the calculation. In the above example, the
“weighting” effect on incremental common shares
for stock options exercised during the period is
factored into the calculation by weighting the
number of stock options outstanding during the
entire period (i.e., one treasury stock method
calculation is performed to calculate the diluted
impact of all stock options). A more precise way
to factor in stock options exercised during the
period is to perform two calculations under the
treasury stock method — one for stock options that
were outstanding for the entire period and one for
stock options that were exercised during the
period. Under this approach, the “weighting”
effect on incremental common shares for stock
options exercised during the period is captured by
multiplying the incremental common shares by a
factor (i.e., percentage) that is determined on
the basis of the period during which the options
were outstanding. See Example 4-2 for
an illustration of this method.
While the more precise calculation may yield
results that do not differ from those under the
simplified approach, an entity should consider its
specific facts and circumstances in determining
when a simplified approach is appropriate. In some
circumstances, a simplified approach could result
in exclusion of the dilutive effect of awards that
were not outstanding during the entire period
because of a difference between the average stock
price during the entire reporting period and the
average stock price during the period in which the
awards were outstanding.
The example below illustrates the application of the treasury stock method to
stock option awards when there is a forfeiture during the period.
Example 7-3
Employee Stock Options — Forfeitures During the Period
Assume the following:
- Entity A has net income of $1 million for the quarter ended March 31, 20X1, as well as 100,000 common shares outstanding for the entire period from January 1, 20X1, to March 31, 20X1.
- On January 1, 20X1, A granted 10,000 employee stock options to 10 employees (1,000 stock options each).
- All the stock options have an exercise price of $5 per option and a grant-date fair-value-based measure of $1 per option, and they cliff vest after two years of service.
- The average market price of A’s common stock for the three-month period ended March 31, 20X1, was $6.50 per share.
- Entity A has a policy of estimating forfeitures, and it estimates that 8,000 of the stock options will eventually vest. It therefore has accrued compensation cost on the basis of this forfeiture estimate.
- On February 1, 20X1, an employee terminates and forfeits 1,000 stock options.
Entity A calculates the number of incremental shares to include in the
denominator of the calculation of diluted EPS
under the treasury stock method, as well as
diluted EPS (for the three-month period ended
March 31, 20X1), as follows:
Note that A must base the calculation of diluted EPS on the actual number of
awards outstanding (i.e., actual forfeitures) in a
given reporting period rather than on its estimate
of the number of awards expected to forfeit. In
addition, note that the above calculation is
simplified because of how forfeitures during the
period are factored into the calculation. In the
above example, the “weighting” effect on
incremental common shares for stock options
forfeited during the period is factored into the
calculation by weighting the number of stock
options outstanding during the entire period
(i.e., one treasury stock method calculation is
performed to calculate the diluted impact of all
stock options). A more precise way to factor in
stock options forfeited during the period is to
perform two calculations under the treasury stock
method — one for stock options that were
outstanding for the entire period and one for
stock options that were forfeited during the
period. Under this approach, the “weighting”
effect on incremental common shares for stock
options forfeited during the period is captured by
multiplying the incremental common shares by a
factor (i.e., percentage) that is determined on
the basis of the period during which the options
were outstanding. See Example 4-2 for
an illustration of this method.
While the more precise calculation may yield
results that do not differ significantly from
those under the simplified approach, an entity
should consider its specific facts and
circumstances in determining when a simplified
approach is appropriate. In some circumstances, a
simplified approach could result in exclusion of
the dilutive effect of awards that were not
outstanding during the entire period because of a
difference between the average stock price during
the entire reporting period and the average stock
price during the period in which the awards were
outstanding.
7.1.2.2 Service Conditions
ASC 260-10
Treatment of Contingently Issuable Shares in Weighted-Average Shares Outstanding
45-13 Shares issuable for little or no cash consideration upon the satisfaction of certain conditions (contingently issuable shares) shall be considered outstanding common shares and included in the computation of basic EPS as of the date that all necessary conditions have been satisfied (in essence, when issuance of the shares is no longer contingent). Outstanding common shares that are contingently returnable (that is, subject to recall) shall be treated in the same manner as contingently issuable shares. Thus, contingently issuable shares include shares that meet any of the following criteria:
- They will be issued in the future upon the satisfaction of specified conditions.
- They have been placed in escrow and all or part must be returned if specified conditions are not met.
- They have been issued but the holder must return all or part if specified conditions are not met.
Share-Based Payment Arrangements
45-32 Fixed grantee stock
options (fixed awards) and nonvested stock
(including restricted stock) shall be included in
the computation of diluted EPS based on the
provisions for options and warrants in paragraphs
260-10-45-22 through 45-27. Even though their
issuance may be contingent upon vesting, they shall
not be considered to be contingently issuable shares
(see Section 815-15-55 and paragraph 260-10-45-48).
However, because issuance of performance-based stock
options (and performance-based nonvested stock) is
contingent upon satisfying conditions in addition to
the mere passage of time, those options and
nonvested stock shall be considered to be
contingently issuable shares in the computation of
diluted EPS. A distinction shall be made only
between time-related contingencies and contingencies
requiring specific achievement.
Generally, an entity will use the treasury stock method to determine the number
of common shares related to share-based payment awards with only a service
condition (i.e., no performance or market condition) to include in the
denominator of the calculation of diluted EPS provided that the awards are
dilutive. (See Section
7.1.2.1.5 for examples illustrating the application of the
treasury stock method to share-based payment awards.)
A restricted stock award is not included in the
denominator of the calculation of basic EPS during the award’s requisite
service period or before the nonemployee award has vested, even if the
shares of stock have been legally issued. Such shares are considered
contingently returnable shares, as described in ASC 260-10-45-13. For
example, if the grantee does not deliver the good or render the service, the
shares are returned to the entity. Once the vesting conditions have been
satisfied, the shares are considered outstanding common shares and therefore
are included in the weighted-average number of common shares outstanding
(i.e., the denominator in the calculation of basic EPS).
In addition, an unexercised stock option award is not
included in the denominator of the calculation of basic EPS even if the
award is vested. That is, even if an award’s vesting conditions have been
satisfied, an unexercised stock option (containing an exercise price that is
not nominal) is not an outstanding common share until it is exercised.
However, an award that contains a right to nonforfeitable dividends or dividend
equivalents that participate in undistributed earnings with common stock is
a participating security even before the award’s vesting conditions have
been satisfied (i.e., during the vesting period). Therefore, the issuer is
required to apply the two-class method discussed in Section 7.1.3 when
calculating basic and diluted EPS. When calculating diluted EPS for unvested
awards that are considered participating securities, an entity must
determine which is more dilutive to apply, the treasury stock method or the
two-class method. See Section 5.5.4 for more information.
In the calculation of diluted EPS, unvested awards and unexercised stock option
awards that vest solely on the basis of a service condition are included in
the denominator of the calculation of diluted EPS during their requisite
service period (or before the nonemployee award has vested) or during the
period the options are unexercised under the treasury stock method.
7.1.2.3 Performance and Market Conditions
ASC 260-10
Share-Based Payment Arrangements
45-31 Awards with a market condition, a performance condition, or any combination thereof (as defined in Topic 718) shall be included in diluted EPS pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-57.
45-32 Fixed grantee stock
options (fixed awards) and nonvested stock
(including restricted stock) shall be included in
the computation of diluted EPS based on the
provisions for options and warrants in paragraphs
260-10-45-22 through 45-27. Even though their
issuance may be contingent upon vesting, they shall
not be considered to be contingently issuable shares
(see Section 815-15-55 and paragraph 260-10-45-48).
However, because issuance of performance-based stock
options (and performance-based nonvested stock) is
contingent upon satisfying conditions in addition to
the mere passage of time, those options and
nonvested stock shall be considered to be
contingently issuable shares in the computation of
diluted EPS. A distinction shall be made only
between time-related contingencies and contingencies
requiring specific achievement.
Contingently Issuable Shares
45-48 Shares whose issuance is contingent upon the satisfaction of certain conditions shall be considered outstanding and included in the computation of diluted EPS as follows:
- If all necessary conditions have been satisfied by the end of the period (the events have occurred), those shares shall be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).
- If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive. Those contingently issuable shares shall be included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).
45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the computation of diluted EPS.
45-50 Paragraphs 260-10-45-51 through 45-54 provide general guidelines that shall be applied in determining the EPS impact of different types of contingencies that may be included in contingent stock agreements.
45-55 Contingently issuable potential common shares (other than those covered by a contingent stock agreement, such as contingently issuable convertible securities) shall be included in diluted EPS as follows:
- An entity shall determine whether the potential common shares may be assumed to be issuable based on the conditions specified for their issuance pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-54.
- If those potential common shares should be reflected in diluted EPS, an entity shall determine their impact on the computation of diluted EPS by following the provisions for options and warrants in paragraphs 260-10-45-22 through 45-37, the provisions for convertible securities in paragraphs 260-10-45-40 through 45-42, and the provisions for contracts that may be settled in stock or cash in paragraph 260-10-45-45, as appropriate.
For share-based payment awards with a performance or market condition, an entity
must first apply the guidance on contingently issuable shares in ASC
260-10-45-48 through 45-55 to determine whether the awards should be
included in the calculation of diluted EPS for the reporting period. That
is, the entity needs to determine the number of awards, if any, that would
be issuable at the end of the reporting period if the end of the reporting
period were the end of the contingency period. Once the entity has
determined that a stock or stock option award should be included in the
calculation of diluted EPS for the reporting period, the entity must use the
treasury stock method to determine the number of incremental shares to
include in the denominator of the calculation of diluted EPS.
An entity may be recording compensation cost for an award that only contains a
performance or market condition because the entity believes that it is
probable that the award will vest (performance condition) or, for example,
that the employee will remain employed for the derived service period
(market condition). However, in such cases, the related incremental shares
would be included in the denominator of the calculation of diluted EPS only
if the performance or market condition (i.e., the contingency) has been met
as of the end of that particular reporting period, under an assumption that
the end of the reporting period is the end of the contingency period.
See Section 4.5 for further discussion of the contingently issuable share method. Section 4.9.4 includes discussion of application of the contingently issuable share method in the calculation of year-to-date diluted EPS.
7.1.2.3.1 Performance-Based Awards
ASC 260-10
Contingently Issuable Shares
45-51 If attainment or maintenance of a specified amount of earnings is the condition and if that amount has been attained, the additional shares shall be considered to be outstanding for the purpose of computing diluted EPS if the effect is dilutive. The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive. Because the amount of earnings may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
45-54 If the contingency is based on a condition other than earnings or market price (for example, opening a certain number of retail stores), the contingent shares shall be included in the computation of diluted EPS based on the assumption that the current status of the condition will remain unchanged until the end of the contingency period. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
Assume that a stock award legally vests only if an entity’s cumulative net
income at the end of the third annual reporting period exceeds $10
million. At the end of each reporting period, the entity assesses
whether cumulative net income has exceeded $10 million as if that
reporting date were the end of the third annual reporting period. If the
performance condition has been met at the end of a reporting period, the
entity includes the award in the calculation of diluted EPS. To
determine the number of incremental shares of stock to include in the
denominator of the calculation of diluted EPS, the entity applies the
treasury stock method if the effect is dilutive on the basis of the
antidilution sequencing requirements of ASC 260.
However, if the entity’s cumulative net income has not exceeded $10 million at
the end of the reporting period, the entity does not include the award
in the calculation of diluted EPS even if it is recording compensation
cost because it believes that it is probable that the award will vest
(i.e., it is probable that the performance target will be achieved). The
entity excludes the award from the calculation of diluted EPS because
the performance condition (i.e., the contingency) has not been met as of
the end of that reporting period.
Example 7-4
Calculating Diluted EPS When Vesting of Stock Options Is Contingent on Future Earnings
Assume the following:
- Entity A has net income of $12 million and $5 million for the year and quarter ended December 31, 20X1, respectively, as well as 5 million common shares outstanding for the quarter ended December 31, 20X1.
- On January 1, 20X1, A granted 1 million employee stock options. The stock options vest on December 31, 20X2, if the recipients remain employed and A’s cumulative net income for the two-year period ended December 31, 20X2, equals or exceeds $10 million.
- As of December 31, 20X1, all the stock options remain outstanding.
- The stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
- The average market price of A’s common stock for the quarter ended December 31, 20X1, was $15 per share.
If the end of the reporting period (December 31, 20X1) is considered the end of
the contingency period, the performance target is
deemed to be achieved. As a result, A includes the
employee stock options in the calculation of
diluted EPS for the quarter ended December 31,
20X1. To determine the number of incremental
shares to include in the calculation’s
denominator, A must then apply the treasury stock
method if the effect is dilutive.
Entity A calculates diluted EPS under the treasury stock method for the
quarterly period ended December 31, 20X1, as
follows:
Alternatively, assume that A had generated net income of less than $10 million for the year ended
December 31, 20X1. In that case, A excludes the employee stock
options from the calculation of diluted EPS
because the contingency is not deemed to have been
met as of the end of the reporting period.
Therefore, A is not required to determine the
number of incremental shares to include in the
denominator of the calculation of diluted EPS
under the treasury stock method. However, if A
believes that it is probable that the performance
target will be attained by the end of the
performance period (December 31, 20X2), A
recognizes compensation cost over the requisite
service period for the number of awards expected
to vest.
There may be other circumstances in which an entity
issues performance-based awards for which performance is calculated on
the basis of an average metric over several periods. When calculating
whether contingently issuable shares for such awards should be included
in the calculation of diluted EPS, an entity applies ASC 260-10-45-51
and ASC 260-10-45-54, which require the entity to assume that the
current status of the condition (e.g., the current amount of earnings)
will remain unchanged until the end of the contingency period. In
addition, footnote (f) to Example 3 in ASC 260-10-55-56 states, in part,
that “[p]rojecting future earnings levels and including the related
contingent shares are not permitted.” Because the guidance precludes the
projection of future earnings levels, earnings (or any other metric) in
future periods would be presumed to be zero. See further discussion in
Section
4.5.2.3. See also the example below.
Example 7-5
Calculating Diluted EPS for an Award That
Vests on the Basis of Average Metrics
On January 1, 20X1, Entity A granted 1 million
performance-based restricted stock units (RSUs) to
a group of its key employees. The RSUs cliff vest
on December 31, 20X3, if the recipients remain
employed and A achieves two performance metrics
during the three-year period from January 20X1 to
December 20X3: (1) a three-year average revenue
growth rate of at least 10 percent and (2) a
three-year average operating margin of at least 6
percent.
The number of contingently issuable shares that
are included in the calculation of diluted EPS is
determined on the basis of the three-year averages
of both the revenue growth rate and operating
margins, which are calculated as follows: (1) the
actual revenue growth rate and operating margin
attained to date and (2) an assumption of zero
revenue growth rate and zero operating margin for
any remaining periods.
Entity A determines the number of shares to
include in the calculation of diluted EPS by using
the following assumptions:
December 31, 20X1
No shares are included in the calculation of
diluted EPS because:
- The three-year average revenue growth rate of 4 percent [(12% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
- The three-year average operating margin of 2 percent [(6% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.
December 31, 20X2
No shares are included in the
calculation of diluted EPS because:
- The three-year average revenue growth rate of 7 percent [(12% for 20X1 + 9% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
- The three-year average operating margin of 4 percent [(6% for 20X1 + 6% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.
December 31, 20X3
The 1 million shares are included in the
calculation of diluted EPS because:
- The three-year average revenue growth rate of 11 percent [(12% for 20X1 + 9% for 20X2 + 12% for 20X3) ÷ 3 years] is above 10 percent.
- The three-year average operating margin of 7 percent [(6% for 20X1 + 6% for 20X2 + 9% for 20X3) ÷ 3 years] is above 6 percent.
As noted in Example 7-1, in the above example,
year-to-date amounts are used for simplicity.
7.1.2.3.2 Market-Based Awards
ASC 260-10
Contingently Issuable Shares
45-52 The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied.
45-53 In some cases, the number of shares contingently issuable may depend on both future earnings and future prices of the shares. In that case, the determination of the number of shares included in diluted EPS shall be based on both conditions, that is, earnings to date and current market price — as they exist at the end of each reporting period. If both conditions are not met at the end of the reporting period, no contingently issuable shares shall be included in diluted EPS.
Assume that a stock award legally vests only if the entity’s share price
increases by more than 20 percent after the grant date. At the end of
each reporting period, the entity would assess whether its share price
has, in fact, increased by more than 20 percent after the grant date.
If, at the end of a reporting period, the market condition has been met,
the entity includes the award in the calculation of diluted EPS. To
determine the number of incremental shares to include in the denominator
of the calculation of diluted EPS, the entity applies the treasury stock
method if the effect is dilutive on the basis of the antidilution
sequencing requirements of ASC 260.
However, if the entity’s share price has not increased by more than 20 percent
at the end of the reporting period, the award is not included in the
calculation of diluted EPS even if the entity is recording compensation
cost because it believes that, for example, the employee will remain
employed for the derived service period. The award is excluded because
the market condition (i.e., the contingency) has not been met as of the
end of that reporting period. Moreover, if an employee does remain
employed for the derived service period, the employee is deemed to have
earned (i.e., vested in) the award. In this circumstance, the entity
will not reverse any previously recognized compensation cost even if the
market condition is never satisfied. If the market condition is never
satisfied, the shares issuable under the award will never become issued
and outstanding. Therefore, the shares will never be included in the
weighted-average number of common shares (i.e., the denominator in the
calculation of basic and diluted EPS).
7.1.3 Participating Securities and the Two-Class Method
ASC 260-10-45-59A through 45-70 (excerpted in Chapter 5) discuss the two-class method of calculating EPS. The two-class method is an earnings allocation formula under which a participating security is treated as having rights to earnings that would have otherwise been available to common shareholders. Entities are required to use the two-class method to calculate basic and diluted EPS if their capital structure includes common stock and either (1) participating securities or (2) multiple classes of common stock.
7.1.3.1 Participating Securities
ASC 260-10 — Glossary
Participating Security
A security that may participate in undistributed earnings with common stock,
whether that participation is conditioned upon the
occurrence of a specified event or not. The form of
such participation does not have to be a dividend —
that is, any form of participation in undistributed
earnings would constitute participation by that
security, regardless of whether the payment to the
security holder was referred to as a dividend.
ASC 260-10
Participating Securities and the Two-Class Method
45-61 Fully vested
share-based compensation subject to the provisions
of Topic 718, including fully vested options and
fully vested stock, that contain a right to receive
dividends declared on the common stock of the
issuer, are subject to the guidance in paragraph
260-10-45-60A.
45-61A Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method under the requirements of paragraph 260-10-45-60A.
Provided that an instrument’s participation feature is nondiscretionary and objectively determinable, the instrument’s classification as a participating security depends on the participation mechanism and the nature of the instrument. Section 5.3 provides additional guidance on the definition of a participating security. Table 5-1 discusses whether instruments typically included in capital structures are considered participating securities.
As noted in the definition of a participating security, participation does not need to be in the form of a dividend. Any participation by a security in the distribution of a company’s earnings (under an assumption that there is a full distribution of earnings) would constitute participation, regardless of whether a cash payment is, or would be accounted for as, a dividend. Example 5-5 provides an illustration.
7.1.3.1.1 Dividend-Paying Share-Based Payment Awards Before Vesting
An award is a participating security if, during the vesting period, it contains
a nonforfeitable right to dividends or dividend
equivalents that participate in the distribution of earnings with common
stock. That is, an award is considered a participating security if it
accrues cash dividends (whether paid or unpaid) any time the common
shareholders receive dividends — when those dividends do not need to be
returned to an entity if the employee (or nonemployee grantee) forfeits
the awards. The entity is required to apply the two-class method when
computing basic and diluted EPS. By contrast, if the right to dividends
or dividend equivalents is forfeitable with the underlying award, the
award is not considered a participating security.
7.1.3.1.2 Dividend-Paying Share-Based Payment Awards After Vesting
After an award has vested, it is a participating security if it contains a right
to receive dividends or dividend equivalents with common shareholders,
because the right is nonforfeitable when the award vests. Therefore, an
entity must apply the two-class method when calculating basic and
diluted EPS unless the award becomes outstanding common shares once
vesting is complete. For example, the two-class method does not apply to
a restricted stock award after a grantee receives outstanding common
shares because the good has been delivered or the service has been
rendered. Once the award becomes outstanding common shares, the entity
includes those shares in the weighted-average number of common shares
outstanding (i.e., the denominator in the calculation of basic EPS).
7.1.3.2 Calculation Under the Two-Class Method
When an entity’s capital structure includes
participating securities but only a single class of common stock, the entity
uses the following three-step process to calculate basic and diluted
EPS:
Step 1 | Use the two-class method to calculate basic EPS.2 |
Step 2 | Use the total earnings allocated to common stock in step 1 to determine diluted EPS. If a participating security is also a potential common share, separately perform steps 2a and 2b to determine the dilutive effect. |
Step 2a | Assume that the participating security has been exercised, converted, or issued; that is, apply the treasury stock method, the if-converted method, or the contingently issuable share method. |
Step 2b | Add back the undistributed earnings allocated to the participating security (or securities) in arriving at basic EPS, and assume that all other dilutive potential common shares have been exercised, converted, or issued in the order of antidilution. Next, reallocate the undistributed earnings — including any additional income that would result from the exercise, conversion, or issuance of potential common shares — to the (1) common shares and potential common shares and (2) participating security (or securities). |
Step 3 | Determine which step — 2a or 2b — results in the more dilutive effect. |
While an entity is required to present, on the face of the income statement, basic and diluted EPS for its common stock, as discussed in Section 9.1.4, the entity is permitted, but not required, to present basic and diluted EPS for a participating security. Section 5.5.4 further discusses the application of the two-class method to the calculation of diluted EPS and includes examples illustrating its application to share-based payment awards.
7.1.4 Settlement in Shares or Cash
ASC 260-10
Share-Based Payment Arrangements
45-30 If share-based payment
arrangements are payable in common stock or in cash at
the election of either the entity or the grantee, the
determination of whether such share-based awards are
potential common shares shall be made based on the
provisions in paragraph 260-10-45-45. If an entity has a
tandem award (as defined in Topic 718) that allows the
entity or the grantee to make an election involving two
or more types of equity instruments, diluted EPS for the
period shall be computed based on the terms used in the
computation of compensation cost for that period.
Contracts That May Be Settled in Stock or Cash
45-45 The effect of potential
share settlement shall be included in the diluted EPS
calculation (if the effect is more dilutive) for an
otherwise cash-settleable instrument that contains a
provision that requires or permits share settlement
(regardless of whether the election is at the option of
an entity or the holder, or the entity has a history or
policy of cash settlement). An example of such a
contract accounted for in accordance with this paragraph
and paragraph 260-10-45-46 is a written call option that
gives the holder a choice of settling in common stock or
in cash. An election to share settle an instrument, for
purposes of applying the guidance in this paragraph,
does not include circumstances in which share settlement
is contingent upon the occurrence of a specified event
or circumstance (such as contingently issuable shares).
In those circumstances (other than if the contingency is
an entity’s own share price), the guidance on
contingently issuable shares should first be applied,
and, if the contingency would be considered met, then
the guidance in this paragraph should be applied.
Share-based payment arrangements that are payable in
common stock or in cash at the election of either the
entity or the grantee shall be accounted for pursuant to
this paragraph and paragraph 260-10-45-46, unless the
share-based payment arrangement is classified as a
liability because of the requirements in paragraph
718-10-25-15 (see paragraph 260-10-45-45A for guidance
for those instruments). If the payment of cash is
required only upon the final liquidation of an entity,
then the entity shall include the effect of potential
share settlement in the diluted EPS calculation until
the liquidation occurs.
45-45A For a share-based
payment arrangement that is classified as a liability
because of the requirements in paragraph 718-10-25-15
and may be settled in common stock or in cash at the
election of either the entity or the holder, determining
whether that contract shall be reflected in the
computation of diluted EPS shall be prepared on the
basis of the facts available each period. It shall be
presumed that the contract will be settled in common
stock and the resulting potential common shares included
in diluted EPS (in accordance with the relevant guidance
of this Topic) if the effect is more dilutive. The
presumption that the contract will be settled in common
stock may be overcome if past experience or a stated
policy provides a reasonable basis to conclude that the
contract will be paid partially or wholly in cash.
45-46 A contract that is
reported as an asset or liability for accounting
purposes may require an adjustment to the numerator for
any changes in income or loss that would result if the
contract had been reported as an equity instrument for
accounting purposes during the period. That adjustment
is similar to the adjustments required for convertible
debt in paragraph 260-10-45-40(b).
45-47 Paragraphs 260-10-55-32 through 55-36A provide additional guidance on contracts that may be settled in stock or cash.
As discussed in Section
4.7, an entity must consider the impact on the calculation of
diluted EPS of a contract indexed to an entity’s common stock that (1) may be
settled in cash or common shares or (2) has an accounting classification that
differs from its assumed settlement for EPS purposes.
Share-based payment awards that cannot be settled in the entity’s shares (e.g.,
liability-classified, cash-settled stock appreciation rights) are not included
in the calculation of basic or diluted EPS. That is, share- based payment awards
that always must be settled in cash are not included in
the denominator in the EPS calculation. However, the compensation cost recorded
in net income (and therefore income available to common stockholders) will
affect the numerator in the EPS calculation.
Conversely, a share-based payment award that can be settled in cash or shares is
evaluated under ASC 260-10-45-45 through 45-47. Subject to one exception,
regardless of whether the election to settle in cash or shares is at the option
of the issuing entity or the holder, the entity must include the incremental
number of shares that results from applying the treasury stock method in the
denominator of the calculation of diluted EPS if the effect is dilutive on the
basis of the antidilution sequencing requirements of ASC 260. If the award is
classified as a liability, an entity may be required to adjust the numerator in
accordance with ASC 260-10-45-46. This adjustment is made to remove the
incremental effect of accounting for the award as a liability (i.e., so that the
numerator reflects only the compensation cost that would have been recognized if
the award had been classified as equity). In addition, in calculating the
average unrecognized cost of the arrangement under the treasury stock method,
the entity should use the amount of cost that would have been left unrecognized
if the award had been classified as equity.
The one exception to the requirement to assume share settlement is related to a
share-based payment award that is classified as a liability because of the
requirements in ASC 718-10-25-15. For these awards, if past experience or a
stated policy provides a reasonable basis for an entity to conclude that the
arrangement will be settled in cash, no incremental shares need to be included
in the denominator of the calculation of diluted EPS.3 In addition, no adjustment to the numerator is needed since the assumed
settlement for diluted EPS is aligned with the accounting classification. See
ASC 260-10-45-45A for additional discussion.
See Sections 4.7 and 4.9.5 for further discussion of contracts that may be settled in cash or stock.
Changing Lanes
ASU 2020-06 eliminated the ability to overcome the
presumption of share settlement for contracts other than share-based
payment arrangements. For share-based payment arrangements, the FASB
decided to retain the existing guidance. Paragraph BC114 of ASU 2020-06
states:
The classification guidance in Topic 718
is different from the classification guidance in Subtopic 815-40.
Specifically, the guidance in paragraph 718-10-25-15 states that “.
. . if an entity that nominally has the choice of settling awards by
issuing stock predominantly settles in cash or if the entity usually
settles in cash whenever a grantee asks for cash settlement, the
entity is settling a substantive liability rather than repurchasing
an equity instrument.” Under current GAAP, a liability-classified
stock-based compensation arrangement may not be included in diluted
EPS because of the existing guidance on contracts that may be
settled in cash or shares. The Board decided to retain the current
guidance for calculating diluted EPS for stock-based compensation
because those arrangements are not within the scope of this project.
7.1.5 Early Exercise of Stock Options
An early exercise refers to a grantee’s ability to change his or her tax
position by exercising an option or similar instrument and receiving shares
before the good has been delivered or the service has been rendered (i.e.,
before the award vests). If the employee terminates employment before rendering
the requisite service (or a nonemployee forfeits the award before completion of
the vesting period), the entity usually can repurchase the shares for either of
the following:
-
The lesser of the fair value of the shares on the repurchase date or the exercise price of the award.
-
The exercise price of the award.
The purpose of the repurchase feature is effectively to require the grantee to
satisfy the vesting conditions to receive any economic benefit from the award.
Early exercise is therefore not considered to be a substantive exercise for
accounting purposes. See Sections 3.4.3 and 5.4.2.3 of Deloitte’s Roadmap Share-Based Payment
Awards for additional information.
7.1.5.1 Basic EPS
The shares issued to a grantee upon an award’s early exercise would not be
considered outstanding for basic EPS purposes until the award’s vesting
conditions have been satisfied. This conclusion is consistent with the
intent of ASC 260-10-45-13, which is that shares that are subject to a
contingent repurchase provision, as described above, are excluded from the
calculation of basic EPS until the shares are no longer contingently
returnable (i.e., the entity’s call option lapses).
However, if the shares subject to repurchase contain nonforfeitable rights to
dividends or dividend equivalents, the shares are participating securities.
That is, an award is considered a participating security if it accrues cash
dividends (whether paid or unpaid) any time the common shareholders receive
dividends that do not need to be returned to the entity if the grantee
forfeits the award. If legally issued shares are considered participating
securities, the entity must use the two-class method to calculate basic EPS.
See Section
7.1.3 for a discussion of the application of the two-class
method to share-based payment awards.
7.1.5.2 Diluted EPS
After a grantee early exercises an option, the entity continues to use the
treasury stock method to calculate diluted EPS. When using this method to
calculate the number of incremental shares to be included in diluted EPS,
the entity normally is required to include the exercise price of the award
in determining the assumed proceeds in accordance with ASC 260-10-45-29.
(See Section
7.1.2.1 for a discussion of the application of the treasury
stock method to share-based payment awards.) However, in this case, because
the grantee has early exercised the award and has therefore already paid
cash, (1) there is no cash that will be received from the grantee in the
future and (2) the cash received could have already been used to repurchase
shares during the requisite service period (or before the nonemployee award
has vested). As a result, the cash received is not included in the
calculation of assumed proceeds.
When calculating diluted EPS for an early-exercised award that is considered a
participating security, an entity must determine whether the treasury stock
method or the two-class method is more dilutive. See further discussion in
Section
5.5.4.
7.1.6 Employee Stock Purchase Plans
7.1.6.1 General
An employee stock purchase plan (ESPP) is a share-based
payment plan that is usually offered to a broad base of employees so that
they can participate in ownership of the entity generally at a discounted
price. Employees contribute to the plan through payroll deductions during
the purchase period (e.g., six months). At the end of the purchase period,
the employer’s stock is purchased at the purchase price, which is generally
a discounted price. See Chapter 8 of Deloitte’s Roadmap Share-Based Payment Awards for
a discussion of ESPPs.
The effect that an ESPP has on an entity’s EPS depends on
the terms of the plan. Generally, the participating employees can choose not
to purchase the shares and can have their withholdings during the purchase
period refunded because either (1) the employees can elect to have previous
withholdings refunded before the end of the purchase period or (2) the
shares will not be purchased if the employee fails to provide the requisite
service (i.e., if the employee terminates employment before the end of the
purchase period). In practice, it is atypical for an employee’s withholdings
during the purchase period not to be refundable because participants are
generally not allowed to purchase shares at the end of the purchase period
if they are no longer employed by the entity. However, the EPS accounting
for ESPPs for which the participating employees are unable to receive a
refund of withholdings made during the purchase period is addressed below.
7.1.6.2 Withholdings Are Not Refundable
If the terms of the ESPP do not allow employees to choose not to purchase the
shares (i.e., the employee’s participation is irrevocable because the employee
is not entitled to a refund of amounts previously withheld during the purchase
period, regardless of whether he or she is terminated), the guidance on
contingently issuable shares applies to the calculation of basic and diluted
EPS. According to this guidance, the number of shares, if any, that would be
issuable at the end of the reporting period, under the assumption that the end
of the reporting period is the end of the purchase period (this number is based
on the amounts withheld by the entity to date), is included in the
weighted-average number of common shares outstanding for both basic and diluted
EPS.
7.1.6.3 Withholdings Are Refundable
7.1.6.3.1 Basic EPS
If the terms of the ESPP allow employees to choose not to
purchase the shares (i.e., employees are entitled to a refund of amounts
previously withheld during the purchase period either at their election or
upon termination of employment), the shares issuable under the ESPP are
treated as employee stock options that are granted as of the beginning of
the purchase period. Accordingly, the shares issuable under the ESPP are not
included in the denominator of the calculation of basic EPS until they have
been actually issued. The fact that the shares issuable under the ESPP are
not included in basic EPS during the purchase period is based on the
guidance in ASC 260-10-45-12C on contingently issuable shares.
7.1.6.3.2 Diluted EPS
As discussed in the previous section, when the terms of the
ESPP allow employees to choose not to purchase the shares, the shares
issuable under the ESPP are treated as employee stock options that are
granted as of the beginning of the purchase period. Accordingly, the shares
issuable under the ESPP are included in the denominator of diluted EPS under
the treasury stock method, as discussed in ASC 260-10-45-22 through 45-29A.
To apply the treasury stock method to an ESPP, an entity must also apply the
guidance on contingently issuable shares, as discussed in ASC 260-10-45-48
and 45-49 and ASC 260-10-45-52.
Because the participants’ ability to purchase shares under
an ESPP is based on a service condition, the grant date and service
inception date are the start date of the purchase period provided that all
the conditions for establishing a grant date have been met. The withholding
of amounts from the employees’ pay during the purchase period merely
represents the funding mechanism for the eventual payment of the exercise
price. This withholding mechanism does not affect the grant date or service
inception date of the ESPP.
The number of incremental common shares to be included in the calculation of
diluted EPS is based on the number of shares that would be issuable if the
reporting date were the end of the contingency period (i.e., the purchase
period) in accordance with ASC 260-10-45-52, net of the hypothetical shares
that could be repurchased in accordance with the treasury stock method.
Therefore, the sponsor of an ESPP must consider each of the following to
calculate the effect of the ESPP on diluted EPS:
-
Employee withholdings — The amount of employee withholdings represents the exercise price for the shares to be purchased by employees and is also used to calculate the number of shares assumed to be issued during the purchase period. For diluted EPS purposes, this amount should represent the total amount of employee withholdings expected to be made during the entire purchase period.4 Entities should consider the elections made by participating employees to estimate this amount.Expected forfeitures may affect the amount of recognized compensation cost during the purchase period but should not be factored into the estimation of employee withholdings. As discussed in Section 7.1.2.1.4, regardless of an entity’s accounting policy election related to how it reflects forfeitures in the recognition of compensation cost, the denominator in the calculation of diluted EPS is based on the actual number of awards outstanding (i.e., the number of awards is reduced only for actual forfeitures) in a given reporting period provided that the effect is dilutive.Changes to employee withholding elections during the purchase period are treated as modifications and are only reflected in EPS prospectively.
- Purchase price formula — The purchase price of an ESPP is generally based on the lesser of the stock price at the beginning of the purchase period and that at the end of the purchase period; therefore, the sponsor will need to consider its stock price as of both the beginning of the purchase period and the end of the reporting period. The stock price as of the end of the reporting period is used as the proxy for the stock price as of the end of the purchase period in accordance with the guidance in ASC 260-10-45-52 on contingently issuable shares. The sponsor would use the lower of these two stock prices to calculate the purchase price when the ESPP allows employees to purchase shares on the basis of a formula that incorporates the lesser of the stock price at the beginning and that at the end of the purchase period.
- Average unrecognized compensation cost — The average amount of unrecognized compensation cost attributable to future service, if any, is a component of the assumed proceeds under the treasury stock method.
The incremental number of common shares included in diluted
EPS is calculated as follows (see also Example 7-6):
Number of shares assumed issued under the ESPP:
Employee withholdings (first bullet above) ÷
purchase price (second bullet above)
Less
Number of shares assumed repurchased:
Assumed proceeds (i.e., employee withholdings
[first bullet above] plus average unrecognized compensation cost
[third bullet above]) ÷ average market price of the issuer’s stock
for the reporting period
Connecting the Dots
Unlike an entity’s accounting for diluted EPS for
early-exercised stock options, an entity may include the money
withheld (and expected to be withheld during the remaining purchase
period) from employees’ pay as a component of the assumed proceeds
in calculating diluted EPS for ESPPs. These withholdings are not
considered a prepayment of the exercise price for diluted EPS
purposes because the entity must refund such amounts to employees
that do not ultimately purchase shares under the ESPP. (This
requirement differs from the terms of early-exercised stock
options.)
Example 7-6
Diluted EPS for ESPP
On July 1, 20X1, Entity A establishes a qualified
ESPP that allows its employees to purchase shares of
its common stock during a six-month purchase period
that begins on July 1, 20X1, and ends on December
31, 20X1. The ESPP allows A’s employees to elect to
withhold up to 10 percent of their salary to
purchase A’s common stock at the end of the purchase
period. Employees may make their election at any
time during the purchase period, but once the
election is made it cannot be changed during the
purchase period. The shares will be purchased at a
price per share that is equal to the lesser of (1)
90 percent of A’s stock price as of July 1, 20X1, or
(2) 90 percent of A’s stock price as of December 31,
20X1. Participants are allowed to withdraw from the
ESPP at any time before the end of the purchase
period and are automatically withdrawn if they are
terminated before the end of the purchase period.
For any such withdrawals, A must refund the amounts
withheld from the participant’s pay. Shares are
issued under the ESPP on January 1, 20X2.
Assumptions related to A’s calculation of diluted EPS
for the quarterly period ended September 30, 20X1,
include the following:
- Common stock prices per share:
- July 1, 20X1 — $50.
- September 30, 20X1 — $40.
- Average market price during the period beginning on July 1, 20X1, and ending on September 30, 20X1 — $45.
- Employee payroll withholdings:
- Actual through September 30, 20X1 — $3.5 million.
- Expected from October 1, 20X1, through December 31, 20X1 — $3.7 million.
- Average unrecognized compensation cost for the period — $1.3 million.
The effect on diluted EPS of the ESPP for the
quarterly period ended September 30, 20X1, is
calculated as follows:
The shares issuable under the ESPP would be included
in basic EPS prospectively once they are issued
(i.e., on January 1, 20X2). While not relevant to
this example, if the purchase period ended during a
quarterly financial reporting period, in addition to
including the shares as outstanding on a
weighted-average basis for the period, an entity
would need to include incremental shares in diluted
EPS on a weighted-average basis for the portion of
the quarterly period for which the shares had not
yet been issued. See Section 4.2.2.1.3.1 for further
discussion.
Connecting the Dots
ASC 260-10-45-21A states:
Changes in an entity’s share price may affect the exercise
price of a financial instrument or the number of shares that
would be used to settle the financial instrument. For example,
when the principal of a convertible debt instrument is required
to be settled in cash but the conversion premium is required to
(or may) be settled in shares, the number of shares to be
included in the diluted EPS denominator is affected by the
entity’s share price. In applying both the treasury stock method
and the if-converted method of calculating diluted EPS, the
average market price shall be used for purposes of calculating
the denominator for diluted EPS when the number of shares that
may be issued is variable, except for contingently issuable
shares within the scope of the guidance in paragraphs
260-10-45-48 through 45-57. See paragraphs 260-10-55-4 through
55-5 for implementation guidance on determining an average
market price.
In accordance with this guidance, the number of
shares assumed to be issued under an ESPP would be calculated by
using the average market price of the entity’s stock. However,
before ASC 260-10-45-21A was added by ASU 2020-06, entities applied
the guidance on contingently issuable shares in ASC 260-10-45-52 to
calculate the number of shares assumed to be issued under an ESPP
(as noted in the guidance and example above). This guidance is
consistent with footnote 1 of FASB Technical Bulletin 97-1
(superseded), which indicated that an entity applies the guidance on
contingently issuable shares to determine the accounting for diluted
EPS.
On the basis of informal discussions with the FASB
staff, we understand that the amendments made to ASC 260 by ASU
2020-06 (i.e., the addition of ASC 260-10-45-21A) were not intended
to address when the guidance on contingently issuable shares applies
to the calculation of diluted EPS. Indeed, ASC 260-10-45-21A
specifically states that these amendments do not apply to
contingently issuable shares. Therefore, the accounting for diluted
EPS that entities applied in practice before adopting ASU 2020-06 is
still acceptable. However, because it is often difficult to
determine when to apply the guidance on contingently issuable shares
in ASC 260, it would also be acceptable for an entity to apply the
guidance in ASC 260-10-45-21A on variable denominators to calculate
the number of shares assumed issued under an ESPP. Such accounting
for diluted EPS would represent an accounting policy election that
must be applied consistently.
If ASC 260-10-45-21A is applied to calculate the
number of shares assumed to be issued in Example 7-6, the number of shares would equal
177,778 (i.e., total expected withholdings of $7,200,000 divided by
$40.50 [$45 average market price for the period multiplied by 90
percent]). As a result, the ESPP would be antidilutive for the
period since the number of shares assumed to be repurchased would be
greater than the number of shares assumed to be issued. This example
illustrates that an entity’s application of ASC 260-10-45-21A to
calculate the number of shares assumed to be issued in an ESPP would
result in less dilution (or no dilution) compared with application
of the contingently issuable share method.
7.1.7 Redeemable Awards
SAB Topic 14.E requires public entities to consider the requirements of ASR 268
(FRR Section 211) and ASC 480-10-S99-3A for redeemable share-based payment
awards. See Section
5.10 of Deloitte’s Roadmap Share-Based Payment Awards for a
discussion of the recognition and measurement requirements for redeemable
share-based payment awards. Also, in addition to the discussion below, see
Section 3.2.4.2
for more information about redeemable common shares.
7.1.7.1 Share-Based Payment Awards Redeemable at Fair Value
Share-based payment awards on common shares that are redeemable at fair value
are accounted for in the same manner as common shares that are redeemable at
fair value. In ASC 480-10-S99-3A, the SEC staff clarified that increases or
decreases in the carrying amount of common shares that are redeemable at
fair value do not affect income available to common stockholders. That is,
changes in the redemption amount do not affect income available to common
stockholders (the numerator in the calculation of basic EPS) if the
redemption value of redeemable shares is based on the fair value of the
shares. When calculating diluted EPS, an entity must apply the treasury
stock method to determine the number of incremental shares to include in the
calculation’s denominator.
7.1.7.2 Share-Based Payment Awards Redeemable at an Amount Other Than Fair Value
Share-based payment awards on common shares that are redeemable at an amount
other than fair value are accounted for in the same manner as common shares
that are redeemable at an amount other than fair value (e.g., formula
price). That is, increases or decreases in the carrying amount of redeemable
share-based payment awards are reflected in EPS under the two-class method,
as discussed in ASC 260-10-45-59A through 45-70. The increase or decrease in
the carrying amount of redeemable share-based payment awards is treated
similarly to the reduction in income from continuing operations (or net
income) from current-period distributions. See Section 7.1.3 for a discussion of the
application of the two-class method. In calculating diluted EPS, an entity
must determine whether the treasury stock method or the two-class method is
more dilutive.
7.1.7.3 Share-Based Payment Awards Redeemable at Intrinsic Value
The SEC’s guidance in ASC 480-10-S99-3A does not address the EPS treatment of
share-based payment awards with a redemption amount that is based on an
award’s intrinsic value. Entities may therefore make a policy decision to
(1) analogize to the guidance in ASC 480-10-S99-3A on common shares that are
redeemable at fair value or (2) treat the increases or decreases in the
carrying amount of these awards as an additive or subtractive amount in
arriving at income available to common stockholders.
Under the first alternative, the increase or decrease in the carrying amount of
the redeemable share-based payment award (i.e., changes in the redemption
amount) does not affect income available to common stockholders (the
numerator in the calculation of basic EPS). Under the second alternative,
however, such an increase or decrease is treated as a preferential
distribution. That is, the entity accounts for the current-period change in
the carrying amount of the redeemable share-based payment award as an
additive or subtractive amount in arriving at income available to common
stockholders (the numerator in the calculation of basic EPS). Regardless of
the alternative selected, the entity must apply the treasury stock method to
determine the number of incremental shares to include in the denominator of
the calculation of diluted EPS.
7.1.7.4 Contingently Redeemable Share-Based Payment Awards
Share-based payment awards on common shares that are contingently redeemable at
fair value or at an amount other than the awards’ fair value (e.g.,
redeemable upon a change in control) do not affect income available to
common stockholders (the numerator in the calculation of basic EPS) until it
is probable that the contingency will occur. That is, awards that are
contingently redeemable are not remeasured to their redemption amount until
it is deemed probable that the contingency will occur. When calculating
diluted EPS, an entity must apply the treasury stock method to determine the
number of incremental shares to include in the denominator of the
calculation.
7.1.8 Awards of a Consolidated Subsidiary
7.1.8.1 Share-Based Payment Awards Issued by a Consolidated Subsidiary and Settled in Subsidiary’s Common Shares
Share-based payment awards issued by a consolidated subsidiary that are settled
by issuing the subsidiary’s common shares affect not only the subsidiary’s
calculation of diluted EPS but also the calculation of the parent’s diluted
EPS, as described in ASC 260-10-55-20 through 55-22 (excerpted in Section 8.8.1.1) and
illustrated in Example 7 in ASC 260-10-55-64 through 55-67 (excerpted in
Section
8.8.1.2).5
While such awards do not affect the weighted-average number of common shares
outstanding (i.e., the denominator in the calculation of basic EPS for
either the subsidiary or the parent), the compensation cost associated with
these awards (during the requisite service period or nonemployee’s vesting
period) will affect both the subsidiary’s and the parent’s net income or
loss.
To calculate the parent’s diluted EPS, the subsidiary must first calculate its
own diluted EPS (regardless of whether the subsidiary reports EPS). The
amount of the subsidiary’s diluted EPS is then multiplied by the number of
the subsidiary’s shares that the parent is assumed to own (after the
hypothetical exercise of the awards is taken into consideration). The
product of those two amounts is then included in the numerator (as a
substitute for the parent’s proportionate share of the subsidiary’s
earnings) of the calculation of the parent’s diluted EPS.
As noted in ASC 260-10-55-21, the guidance in ASC 260-10-55-20 also applies to investments in common stock of corporate joint ventures and investee companies that are accounted for under the equity method.
Example 7-7
Impact on EPS of Share-Based Payment Awards Issued by a Subsidiary
Assume that the following apply to Parent P:
-
Its net income is $100, excluding any net income or loss of Subsidiary A (i.e., as if A is unconsolidated).
-
Throughout the period, 100 shares of its common stock were outstanding. No other securities have been issued.
-
It owns 90 of A’s common shares (out of 100 outstanding).
Assume that the following apply to A:
- Its net income is $100 (after intercompany eliminations, etc.).
- Throughout the period, 100 shares of its common stock were outstanding.
- At the beginning of the period, it granted 10 fully vested stock options to its employees to purchase 10 shares of its common stock at $1 per share.
- The average market price of its common stock during the period is $2 per share.
The calculation of A’s diluted EPS is as follows:
7.1.8.2 Share-Based Payment Awards Issued by a Subsidiary but Settled in the Parent’s Common Shares
Share-based payment awards issued by a consolidated subsidiary that are settled
by issuing the parent’s common shares will not affect the subsidiary’s
denominator in the calculation of diluted EPS because the awards do not
represent potential common shares of the subsidiary. However, during the
awards’ requisite service period or nonemployee’s vesting period, the
compensation cost associated with them will affect the subsidiary’s net
income or loss. (See Sections 2.8 and 2.9 of Deloitte’s Roadmap Share-Based Payment
Awards for a discussion of the accounting for
share-based payment awards issued by a subsidiary but settled in the
parent’s common shares.)
By contrast, for the parent, the share-based payment awards do represent
potential common shares in the calculation of diluted EPS. Therefore, the
awards are included in the parent’s denominator of the calculation of
diluted EPS under the treasury stock method. Because the subsidiary is
recording compensation cost in its financial statements for these awards
during the requisite service period or nonemployee’s vesting period, the
parent’s proportionate share of the compensation cost will have been
included in the parent’s net income or loss.
Footnotes
1
The inclusion of the average amount of
unrecognized cost attributed to future goods or services not yet
recognized is unique to share-based payment awards. That is,
this component is only included in the assumed proceeds for
share-based payment awards.
2
Undistributed losses would
generally not be allocated to share-based payment
awards in accordance with ASC 260-10-45-67 because
they typically would not have a “contractual
obligation to share in the losses of the issuing
entity on a basis that was objectively
determinable.” See Section 5.5.2.2
for more information.
3
An entity would need to have a sufficient past practice
of cash settlement as well as evidence of its intent to cash-settle the
arrangement.
4
The entire purchase period is considered
in the calculation of diluted EPS because the shares to
be purchased under the ESPP are treated as employee
stock options. Therefore, all amounts to be withheld
from employees’ pay to purchase shares under the ESPP
(i.e., withholdings to date and expected future
withholdings during the remaining purchase period) must
be considered in the calculation of diluted EPS.
5
See Section 8.8 for further
discussion of how to calculate EPS for a parent with a
less-than-wholly-owned subsidiary.
7.2 Employee Stock Ownership Plans
7.2.1 General
7.2.1.1 Background
An ESOP is a qualified defined-contribution employee benefit plan designed to invest primarily in the stock of the sponsoring entity (referred to hereafter as the “sponsor”). ESOPs are “qualified” in the sense that the sponsor receives certain tax benefits because the plan meets the ESOP requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986 (IRC) as either a stock bonus plan or a combination of a stock bonus plan and a money purchase pension plan. Further, an ESOP:
- Is organized through a trust fund and is generally funded through contributions made by the sponsor.
- Must hold qualified common stock of the sponsor or noncallable preferred stock that is convertible into qualified common stock of the sponsor.6
- May issue debt to fund the acquisition of shares of the sponsor. Loans owed by an ESOP may be entered into with the sponsor or with a third party. See Section 7.2.1.2 for further discussion of the difference between a leveraged ESOP and a nonleveraged ESOP.
The sponsor may make contributions to the ESOP through various means. It may issue its shares to the ESOP; make contributions of cash to the ESOP so that the ESOP can purchase the sponsor’s shares in the market; or make principal and interest payments on debt owed by the ESOP, resulting in the release of shares that serve as collateral on the ESOP’s debt. The shares held by an ESOP are either allocated or unallocated. Allocated shares represent shares held by an ESOP that have been assigned to the accounts of individual employee participants (referred to hereafter as “participants”). Allocated shares are generally subject to vesting requirements. Shares held by an ESOP that have not been assigned to individual participant accounts represent unallocated shares. As of the end of an ESOP’s fiscal year, generally only leveraged ESOPs have unallocated shares.
Participants do not pay taxes on allocated shares until they receive a taxable
distribution from the ESOP. Upon termination of employment, participants may
be able to “roll over” their vested shares into another qualified plan to
defer taxation on the distribution. In some ESOPs, the vested shares of
participants are repurchased by the sponsor or by the ESOP as of the date on
which the participant’s employment is terminated. If the shares of common
stock or convertible preferred stock held by an ESOP are not readily
tradable, by law the sponsor must typically provide a put option that gives
participants the right, but not the obligation, to sell vested shares at an
amount generally designed to represent fair value (see further discussion in
Section
7.2.4.2.1). Any unvested allocated shares of a participant
that terminates employment are redesignated as unallocated shares and
subsequently allocated to other participants.
Dividends paid on the sponsor’s stock may be distributed or allocated in various ways, including:
- Dividends on allocated and unallocated shares held by an ESOP may be used to repay a loan owed by the ESOP. In these situations, the ESOP generally pays the dividend equivalent on allocated shares in additional shares of stock.
- Dividends on allocated shares could be paid to participants in cash or through an allocation of additional shares with a value equal to the cash amount of the dividends.
- Dividends on unallocated shares could be paid to participants in cash or through the allocation of additional shares of stock on the basis of a specified allocation formula (typically, the participant’s account balance).
ASC 718-40 addresses the accounting by sponsors of all ESOPs. Entities may sponsor other types of stock ownership plans that do not meet the definition of an ESOP because those plans do not meet the requirements for an ESOP in ERISA and the IRC. Those arrangements are subject to the accounting specified in other Codification subtopics.
Changing Lanes
The guidance in ASC 718-40 was codified from AICPA Statement of Position (SOP) No. 93-6, which superseded the previous guidance in SOP 76-3 (as interpreted by EITF Issue 89-8). Sponsors were required to apply SOP
93-6 to all shares acquired by an ESOP on or after January 1, 1993.
While sponsors were encouraged to prospectively adopt SOP 93-6 for
shares acquired by ESOPs before January 1, 1993, sponsors that did
not elect to adopt SOP 93-6 for all shares owned by an ESOP would
continue to apply the guidance in SOP 76-3 to the grandfathered ESOP
shares (see ASC 105-10-70-2(c)). The guidance in SOP 76-3 was not
codified, in part, because it was no longer expected to be widely
applicable. Section 7.2.3.4 discusses the application of SOP
76-3 to leveraged ESOPs. The remaining guidance below is based on
the requirements of ASC 718-40.
7.2.1.2 Leveraged Versus Nonleveraged ESOPs
For accounting purposes, it is important to distinguish between leveraged ESOPs and nonleveraged ESOPs. This is because the accounting and EPS requirements in ASC 718-40 differ significantly for the two different types of ESOPs. A leveraged ESOP is an ESOP that enters into a loan arrangement to acquire shares of the sponsor. A nonleveraged ESOP is an ESOP that does not enter into loans to acquire shares of the sponsor.
A leveraged ESOP may enter into a loan with a third party or with the sponsor. A loan entered into between an ESOP and a third-party lender is referred to as a direct loan. When an ESOP enters into a loan directly with a third party, the repayment of the loan is generally guaranteed by the sponsor. A loan entered into between an ESOP and the sponsor, with a related outside loan between the sponsor and a third-party lender, is referred to as an indirect loan. If an ESOP enters into a loan with the sponsor and the sponsor does not obtain a related loan with a third-party lender, the ESOP is considered internally leveraged and the loan between the ESOP and sponsor is an intercompany loan.
Loans with third parties must be reflected as debt on the sponsor’s balance
sheet regardless of whether they are direct loans or indirect loans. Loans
between a sponsor and an ESOP may not be reflected as assets or liabilities
on the sponsor’s balance sheet. Thus, when an ESOP is only internally
leveraged, the accounting relevant to leveraged ESOPs applies but no
liability related to the ESOP’s debt is reflected on the sponsor’s balance
sheet.
7.2.2 Nonleveraged ESOPs
7.2.2.1 General
In accordance with ASC 718-40-25-19, a sponsor of a nonleveraged ESOP reports compensation cost in each financial reporting period on the basis of the contributions that are required for the period under the terms of the plan, regardless of whether those contributions are made in cash or stock. When contributions are made in stock, the fair value of the stock contributed is used to measure compensation cost. Tax law requires sponsors to allocate the amounts contributed to individual participant accounts as of the end of the ESOP’s fiscal year. While the participants are generally subject to vesting requirements, any vesting requirements (and any forfeitures resulting from a failure to meet these requirements) have no impact on the prior compensation cost recognized by the sponsor. Any forfeited account balances are reallocated to other participants and could only indirectly reduce the subsequent-period compensation cost because of the reduction in the required contributions for that period.
Under ASC 718-40, if a nonleveraged ESOP does not hold shares related to the
reversion of assets from another terminated employee benefit plan, the
sponsor will not need to recognize any unearned ESOP compensation expense
(contra-equity) account in a manner similar to how such accounts are
recognized by sponsors of leveraged ESOPs. However, such a situation does
not obviate the need for sponsors to estimate and accrue compensation
expense during interim periods. Example 1 in ASC 718-40-55-34 through 55-38
illustrates the journal entries that must be recorded by a sponsor of a
nonleveraged ESOP that holds common stock.
The impact of a nonleveraged ESOP on the sponsor’s calculation of basic and diluted EPS is relatively straightforward. ASC 718-40-45-1 and ASC 718-40-45-9 contain the EPS accounting requirements for nonleveraged ESOPs.
ASC 718-40
EPS
45-1 Dividends on preferred
stock held by an employee stock ownership plan shall
be deducted from net income net of any applicable
income tax benefit when computing both basic and
diluted earnings per share (EPS) if that preferred
stock is considered outstanding (that is, if the
employee stock ownership plan shares are allocated).
EPS
45-9 All shares held by a
nonleveraged employee stock ownership plan shall be
treated as outstanding in computing the employer’s
earnings per share (EPS), except the suspense
account shares of a pension reversion employee stock
ownership plan, which are not treated as outstanding
until they are committed to be released for
allocation to participant accounts. If a
nonleveraged employee stock ownership plan holds
convertible preferred stock, the guidance in
paragraphs 718-40-45-6 through 45-8 for leveraged
employee stock ownership plans shall be considered.
As noted in the guidance above, the calculation of basic and diluted EPS by a sponsor of a nonleveraged ESOP is affected by dividends paid on any convertible preferred stock held by the ESOP, the outstanding shares of common stock held by the ESOP, and the application of the if-converted method when the ESOP holds convertible preferred stock. In addition, any redemptions of convertible preferred stock and the redemption provisions of common stock or convertible preferred stock held by the ESOP could also affect EPS.
Connecting the Dots
Unlike an entity that accounts for leveraged ESOPs, an entity that accounts for
nonleveraged ESOPs would consider all shares of common stock or
convertible preferred stock held by the ESOP to be outstanding
shares in the calculation of EPS. The only exception applies to
suspense account shares of a pension reversion ESOP, which are not
treated as outstanding until they are committed to be released for
allocation to participant accounts (referred to hereafter as
“suspense pension reversion shares”).7 The EPS treatment of outstanding shares is considered the
same, regardless of whether those shares are fully vested or remain
subject to vesting requirements. The forfeiture of allocated shares
would only affect future financial reporting periods to the extent
that the sponsor’s required contributions are less because of the
reallocation of forfeited shares.
7.2.2.2 Dividends
7.2.2.2.1 Dividends on Common Stock
Dividends paid on shares of common stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares are charged to retained earnings. The payment of such dividends will generally have no impact on basic or diluted EPS unless they are paid in additional shares of common stock (i.e., unless they increase the outstanding shares of common stock held by the ESOP). If the sponsor has multiple classes of common stock or participating securities and is required to apply the two-class method, the shares of common stock held by the ESOP that are not considered suspense pension reversion shares will be treated in the same manner as other outstanding shares of common stock of the same class issued by the sponsor to other investors. See Section 7.2.4.4 and Chapter 5 for further discussion of the two-class method.
Connecting the Dots
Because all shares of common stock held by a nonleveraged ESOP are considered
outstanding regardless of vesting requirements, the unvested
portion of participants’ allocated shares are not considered
participating securities.
7.2.2.2.2 Dividends on Convertible Preferred Stock
Section 3.2.2
discusses the general requirement to adjust net income (loss) for
dividends on preferred stock to arrive at income available to common
stockholders, which is the numerator in the calculation of EPS. ASC
718-40-45-1 explains that this general requirement applies to all shares
of convertible preferred stock held by a nonleveraged ESOP, other than
any suspense pension reversion shares. Dividends on outstanding shares
of convertible preferred stock should include undistributed earnings of
the sponsor if the outstanding shares of convertible preferred stock
held by the nonleveraged ESOP meet the definition of a participating
security. For example, if the shares of convertible preferred stock
allocated to participants (whether vested or unvested) contain rights to
participate in dividends with common shareholders, the allocated shares
of convertible preferred stock held by a nonleveraged ESOP would meet
the definition of a participating security. See Section 5.3 for
further discussion of the definition of a participating security.
7.2.2.3 Outstanding Shares
7.2.2.3.1 Common Stock
All shares of common stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares are considered outstanding, and the sponsor must include such shares in the denominator of both basic and diluted EPS on a weighted-average basis. The treatment of such shares is the same as that for outstanding shares of common stock owned by investors. See Section 7.2.4 for additional considerations related to situations in which a nonleveraged ESOP holds shares of common stock that are redeemable at the option of the participant or upon the occurrence of events outside the control of the sponsor.
Connecting the Dots
Given the recognition guidance in ASC 718-40 that applies to nonleveraged ESOPs, any vesting requirements associated with allocated shares of common stock held by an ESOP have no bearing on the impact of those shares on basic and diluted EPS.
7.2.2.3.2 Convertible Preferred Stock
A sponsor’s basic EPS will be affected by shares of convertible preferred stock held by a nonleveraged ESOP as a result of the payment of dividends (see Section 7.2.2.2.2), redemptions, and remeasurement adjustments under ASC 480-10-S99-3A. Redemptions of preferred stock are addressed in Section 3.2.2.6. That guidance applies to redemptions of convertible preferred stock held by a nonleveraged ESOP even if the redeemed shares remain in the ESOP for reallocation to other participants. See Section 7.2.4 for additional considerations related to situations in which a nonleveraged ESOP holds shares of convertible preferred stock that are redeemable at the option of the participant or upon events outside the control of the sponsor.
A sponsor’s diluted EPS will be further affected by the application of the
if-converted method to the weighted-average number of shares of
convertible preferred stock held by a nonleveraged ESOP. The
if-converted method should be applied to all shares of convertible
preferred stock held by a nonleveraged ESOP that are not considered
suspense pension reversion shares. Section 4.4.1 discusses the
general requirement to apply the if-converted method to convertible
preferred stock in the calculation of diluted EPS. ASC 718-40-45-6
through 45-8 (excerpted in Section 7.2.3.1) further describe
how the if-converted method is applied to convertible preferred stock
held by a leveraged ESOP. ASC 718-40-45-9 explains that this guidance is
also relevant to the accounting for a nonleveraged ESOP that holds
convertible preferred stock. See Section 7.2.3.3.2 for further
discussion.
Connecting the Dots
Given the recognition guidance in ASC 718-40 that applies to nonleveraged ESOPs, any vesting requirements associated with allocated shares of convertible preferred stock held by an ESOP have no bearing on the impact of those shares on basic and diluted EPS.
7.2.3 Leveraged ESOPs
7.2.3.1 General
The sponsor’s recognition and measurement of transactions involving leveraged ESOPs is more complicated than the accounting for nonleveraged ESOPs. The additional complications arise because a leveraged ESOP borrows money to acquire shares of common stock or convertible preferred stock of the sponsor and initially holds those shares in a suspense account. In contrast, a nonleveraged ESOP generally only holds common shares or convertible preferred shares that have been allocated to participants.
The shares held in the suspense account by a leveraged ESOP are referred to as suspense shares. Suspense shares are shares that have not been released, committed to be released, or allocated to participant accounts. Such shares generally collateralize the debt of a leveraged ESOP. The ESOP typically repays amounts on the borrowed funds as it receives contributions from the sponsor and dividends on the shares held. As the ESOP’s debt is repaid, suspense shares are allocated to participant accounts.
ASC 718-40-25-10 specifies that the sponsor must initially report the issuance of shares, sale of treasury shares, or acquisition of shares in the market by a leveraged ESOP as outstanding shares, with a “corresponding charge to unearned [ESOP] shares, a contra-equity account.” As shares are committed to be released, the contra-equity account for the unearned ESOP shares is credited with an offsetting debit to compensation cost, dividends payable, or other liabilities, depending on the specific purpose for the release of shares. Compensation cost is measured at the fair value of the shares as of the date the shares are committed to be released; any difference between the fair value and the original cost of the shares that is credited to the contra-equity account for the unearned ESOP shares is recognized as an adjustment to APIC. At any point in time, a leveraged ESOP will hold shares of common stock or convertible preferred stock that are considered suspense shares. Such shares are reflected in the sponsor’s balance sheet as unearned ESOP shares, a contra-equity account.
The above discussion serves as a high-level overview of the recognition and measurement guidance for leveraged ESOPs. For the specific recognition and measurement requirements applicable to leveraged ESOPs, sponsors should look to the accounting guidance in ASC 718-40.
ASC 718-40 contains the following guidance
relevant to the EPS accounting for sponsors of leveraged ESOPs:
ASC 718-40
EPS
45-1 Dividends on preferred
stock held by an employee stock ownership plan shall
be deducted from net income net of any applicable
income tax benefit when computing both basic and
diluted earnings per share (EPS) if that preferred
stock is considered outstanding (that is, if the
employee stock ownership plan shares are
allocated).
Issuance of Shares or the Sale of Shares to an Employee Stock Ownership Plan
45-2 Paragraph 718-40-25-10 states that an employer shall report the issuance of shares or the sale of treasury shares to an employee stock ownership plan when they occur and shall report a corresponding charge to unearned employee stock ownership plan shares, a contra-equity account. That account should be presented as a separate item in the balance sheet.
EPS
45-3 For purposes of
computing basic and diluted earnings per share
(EPS), employee stock ownership plan shares that
have been committed to be released shall be
considered outstanding. Employee stock ownership
plan shares that have not been committed to be
released shall not be considered outstanding.
45-4 Employers that use
dividends on allocated employee stock ownership plan
shares to pay debt service shall adjust earnings
applicable to common shares in the if-converted
computation for the difference (net of income taxes)
between the amount of compensation cost reported and
the amount of compensation cost that would have been
reported if the allocated shares had been converted
to common stock at the beginning of the period.
45-5 Prior period EPS shall not be restated for changes in the conversion rates.
Convertible Preferred Shares
45-6 The number of common shares that will be issued on conversion of the convertible shares held by an employee stock ownership plan that have been committed to be released shall be deemed outstanding in the if-converted EPS computations for diluted EPS if the effect is dilutive. Convertible preferred shares held by the employee stock ownership plan that have not been committed to be released shall not be considered outstanding and, accordingly, would be excluded from the if-converted computations for diluted EPS.
45-7 When participants
withdraw account balances containing convertible
preferred shares from an employee stock ownership
plan, they may be entitled to receive common shares
or cash with a value equal to either the fair value
of the convertible preferred shares or a stated
minimum value per share. Accordingly, if the value
of the common stock issuable is less than the stated
minimum value or the fair value of the preferred,
participants may receive common shares or cash with
a value greater than the value of the common shares
issuable at the stated conversion rate. In
determining EPS, the employer shall presume that
such a shortfall will be made up with shares of
common stock. However, that presumption may be
overcome if past experience or a stated policy
provides a reasonable basis to believe that the
shortfall will be paid in cash. In applying the
if-converted method, the number of common shares
issuable on assumed conversion, which shall be
included in the denominator of the EPS calculation,
shall be the greater of the following:
-
The shares issuable at the stated conversion rate
-
The shares issuable if the participants were to withdraw the shares from their accounts.
45-8 Shares issuable on assumed withdrawal shall be computed based on the ratio of the average fair value of the convertible stock (or, if greater, its stated minimum value) to the average fair value of the common stock.
The calculation of basic and diluted EPS by a sponsor of a leveraged ESOP
differs significantly from the EPS accounting by a sponsor of a nonleveraged
ESOP because, unlike shares held by nonleveraged ESOPs, all shares held by
leveraged ESOPs are not considered outstanding for EPS purposes. This
difference exists because the unallocated shares serve as collateral on the
loan obligation of a leveraged ESOP. According to ASC 718-40-45-3, shares
held by a leveraged ESOP that have been either allocated or committed to be
released (on the basis of the debt service payments) should be considered
outstanding in the calculation of EPS. Shares that have not been committed
to be released should not be included in the calculation of either basic or
diluted EPS. As with the accounting for nonleveraged ESOPs, the vested
status of a leveraged ESOP’s outstanding shares is not relevant to the
sponsor’s calculation of basic and diluted EPS.
7.2.3.2 Dividends
7.2.3.2.1 Dividends on Common Stock
Dividends paid on shares of common stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1) are charged to retained earnings. The payment of such dividends will generally have no impact on basic or diluted EPS unless they are paid in additional shares of common stock (i.e., unless they increase the outstanding shares of common stock held by the ESOP). If the sponsor has multiple classes of common stock or participating securities and is required to apply the two-class method, the shares of common stock held by the ESOP that are considered outstanding will be treated in the same manner as other outstanding shares of common stock of the same class issued by the sponsor to other investors. See Section 7.2.4.4 and Chapter 5 for further discussion of the two-class method.
Connecting the Dots
Generally, all dividends paid in cash on all shares of common stock held by a leveraged ESOP are used for debt service and the ESOP allocates additional shares of common stock to participants as a substitute payment of dividends on allocated shares. Provided that the monetary value of the additional allocated shares equals the cash amount of the dividends, the only additional impact on EPS that will result from the payment of dividends in additional shares of common stock is the additional number of outstanding shares of common stock that are included in the denominator.
Because all shares of common stock held by a leveraged ESOP that are allocated
(including committed-to-be-released shares) are considered
outstanding regardless of vesting requirements, the unvested
portion of shares of common stock allocated to participants is
not considered participating securities. Although atypical, if
dividends on unallocated shares of common stock are paid to
participants or added to participant accounts, the sponsor must
treat those dividends as additional compensation expense in
accordance with ASC 718-40-25-16. In these circumstances, the
sponsor should consider whether the two-class method should be
applied to its undistributed earnings.
7.2.3.2.2 Dividends on Convertible Preferred Stock
Section 3.2.2 discusses the general requirement to adjust net income (loss) for dividends on preferred stock to arrive at income available to common stockholders, which is the numerator in the calculation of EPS. ASC 718-40-45-1 explains that this general requirement applies to all shares of convertible preferred stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1). Dividends on outstanding shares of convertible preferred stock should include undistributed earnings of the sponsor if the outstanding shares of convertible preferred stock held by the leveraged ESOP meet the definition of a participating security. See Section 5.3 for further discussion of the definition of a participating security.
Connecting the Dots
Generally, all dividends paid in cash on shares of convertible preferred stock held by a leveraged ESOP are used for debt service and the ESOP allocates additional shares of convertible preferred stock to participants as substitute payment of dividends on allocated shares. Provided that the monetary value of the additional allocated shares equals the cash amount of the dividends, the only additional impact on EPS that will result from the payment of dividends in additional shares of convertible preferred stock is the additional number of outstanding shares of convertible preferred stock that are used in the calculation of diluted EPS under the if-converted method (see Section 7.2.3.3.2).
If the shares of convertible preferred stock allocated to participants (whether
vested or unvested) contain rights to participate in dividends
with common shareholders, the allocated shares of convertible
preferred stock held by a nonleveraged ESOP would meet the
definition of a participating security. Although atypical, if
dividends on unallocated shares of convertible preferred stock
are paid to participants or added to participant accounts, the
sponsor must treat such dividends as additional compensation
expense in accordance with ASC 718-40-25-16. In these
circumstances, the sponsor should also consider whether the
two-class method should be applied to its undistributed
earnings.
7.2.3.3 Outstanding Shares
7.2.3.3.1 Common Stock
Shares of common stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1) must be included in the denominator of both basic and diluted EPS on a weighted-average basis. The treatment of such shares is the same as that for outstanding shares of common stock owned by investors. See Section 7.2.4 for additional considerations related to situations in which a leveraged ESOP holds shares of common stock that are redeemable at the option of the participant or upon the occurrence of events outside the sponsor’s control.
Connecting the Dots
As with nonleveraged ESOPs, the vesting requirements associated with outstanding shares of common stock held by a leveraged ESOP have no bearing on the impact of those shares on basic and diluted EPS.
7.2.3.3.2 Convertible Preferred Stock
A sponsor’s basic EPS will be affected by shares of convertible preferred stock held by a leveraged ESOP as a result of dividend payments (see Section 7.2.3.2.2), redemptions, and remeasurement adjustments under ASC 480-10-S99-3A. Redemptions of preferred stock are addressed in Section 3.2.2.6. That guidance applies to redemptions of convertible preferred stock held by a leveraged ESOP even if the redeemed shares remain in the ESOP for reallocation to other participants. See Section 7.2.4 for additional considerations related to situations in which a leveraged ESOP holds shares of convertible preferred stock that are redeemable at the option of the participant or upon the occurrence of events outside the control of the sponsor.
A sponsor’s diluted EPS will be further affected by the application of the
if-converted method to the weighted-average number of shares of
convertible preferred stock held by a leveraged ESOP that are considered
outstanding (as discussed in Section 7.2.3.1). Section 4.4.1
discusses the general requirement to apply the if-converted method to
convertible preferred stock in the calculation of diluted EPS. ASC
718-40-45-6 through 45-8 further describe how the if-converted method is
applied to convertible preferred stock held by a leveraged ESOP. That
guidance explains that, for diluted EPS purposes, the following should
be considered:
-
In the calculation of adjustments to the numerator related to the assumed conversion of convertible preferred stock into common stock, in addition to the adjustment for dividends on the convertible preferred stock that would not have been paid during the period if the convertible preferred stock had been converted into common stock, adjustments are also needed for the difference in tax benefits and compensation cost that would exist if the convertible preferred stock had been converted into common stock. See the examples in Sections 7.2.3.5.3 and 7.2.3.5.4.
-
Upon withdrawal of account balances, participants may be required, or may have the right, to either convert their shares of convertible preferred stock into shares of common stock or receive a cash amount equal to the conversion value. The amount of cash or the number of shares of common stock received upon conversion may equal the greater of (1) the if-converted value based on the stated conversion terms or (2) a stated minimum amount of the convertible preferred stock. The potential dilution calculated under the if-converted method must be the greater of those two amounts. In addition, the more dilutive of the two-class method or the if-converted method must be applied if the outstanding shares of convertible preferred stock meet the definition of a participating security. See further discussion in Section 5.5.4.
Connecting the Dots
In the calculation of diluted EPS, it is presumed that a contract that may be
settled in cash or shares will be settled in shares. This
presumption may not be overcome; therefore, a sponsor must apply
the if-converted method to calculate the effect on diluted EPS
of convertible preferred stock held by a leveraged ESOP.
However, the numerator in the calculation may be affected in
accordance with the guidance in ASC 260 on contracts that may be
settled in cash or stock. (See further discussion in Section
4.7.)
7.2.3.4 Accounting Under SOP 76-3
AICPA SOP 76-3
.11 The
Division believes that all shares held by an ESOP
should be treated as outstanding shares in the
determination of earnings per share. An ESOP is a
legal entity holding shares issued by the employer,
whether or not those shares have been allocated to
employee accounts.
.12
Dividends paid on shares held by an ESOP should be
charged to retained earnings. Such dividends should
not be included at any time in compensation expense.
As discussed in Section
7.2.1.1, certain sponsors may still be applying the grandfathered guidance in SOP 76-3, as interpreted in EITF Issue 89-8, for shares acquired by leveraged ESOPs before January 1, 1993 (see ASC 105-10-70-2(c)). Under SOP 76-3, the accounting principles for nonleveraged ESOPs are the same as those for leveraged ESOPs. Sponsors that account for a leveraged ESOP in accordance with SOP 76-3 should charge all dividends to retained earnings and all shares held by a leveraged ESOP, regardless of whether they are allocated to participants, should be included in the denominator for both basic and diluted EPS. In EITF Issue 92-3, the Task
Force reached a consensus that the tax benefits from dividends on
unallocated stock held by a leveraged ESOP, which are recognized in retained
earnings along with those dividends, should not be an adjustment to net
income in the calculation of EPS. The Task Force noted that this consensus
also applies to the application of the if-converted method to convertible
preferred stock held by a leveraged ESOP.
The example below illustrates the accounting by
a sponsor of a leveraged ESOP with shares of common stock accounted for
under both SOP 76-3 and ASC 718-40.
Example 7-8
ESOP Shares Accounted for Under SOP 76-3 and ASC 718-40
Assume the following:
- Entity A has sponsored an ESOP that holds shares of its common stock.
- The ESOP has three direct loans.
- The ESOP has unallocated shares that pertain to all three loans.
- Shares of common stock purchased with the proceeds of the first loan were acquired before January 1, 1993, and are being accounted for under SOP 76-3 (as interpreted by EITF Issue 89-8).
- Shares of common stock purchased with the proceeds of the second and third loans were acquired after December 31, 1992, and are being accounted for under ASC 718-40.
In the calculation of EPS, the unallocated shares of common stock pertaining to the first loan should be considered outstanding and included in the denominator in the calculations of both basic and diluted EPS. The unallocated shares of common stock pertaining to the second and third loans should not be considered outstanding in the denominator in the calculations of basic and diluted EPS until they have been committed to be released. All allocated shares of common stock held by the ESOP are included in the denominator in the calculations of both basic and diluted EPS. The accounting policies for each block of shares should be disclosed in the financial statements.
7.2.3.5 EPS Examples
ASC 718-40 includes four comprehensive examples illustrating the accounting for leveraged ESOPs. Those examples are shown below.
7.2.3.5.1 Common Stock Leveraged ESOP With a Direct Loan
ASC 718-40-55-4 through 55-8 contain an example illustrating an ESOP that owns common stock and is leveraged through a direct loan. The example addresses the impact on the sponsor’s basic and diluted EPS.
ASC 718-40
Case A: A Common-Stock Leveraged Employee Stock Ownership Plan With a Direct Loan
55-4 This Case illustrates a common stock leveraged employee stock ownership plan with a direct loan. This Case has the following assumptions:
- On January 1, Year 1, Entity A establishes a leveraged employee stock ownership plan.
- The employee stock ownership plan borrows $1,000,000 from an outside lender at 10 percent for 5 years and uses the proceeds to buy 100,000 shares of newly issued common stock of the sponsor for $10 per share, which is the market price of those shares on the date of issuance.
- Debt service is funded by cash contributions and dividends on employer stock held by the employee stock ownership plan.
- Dividends on all shares held by the employee stock ownership plan are used for debt service.
- Cash contributions are made at the end of each year.
- The year-end and average market values of a share of common stock follow.
- The common stock pays normal dividends at the end of each quarter of 12.5 cents per share ($50,000 for the employee stock ownership plan’s shares each year). Accordingly, in this Case, the average fair value of shares is used to determine the number of shares used to satisfy the employers’ obligation to replace dividends on allocated shares used for debt service.
- Principal and interest are payable in equal annual installments at the end of each year. Debt service is as follows.
- The number of shares released each year is as follows.
- The number of shares released for dividends is determined by dividing the amount of dividends on allocated shares by the average fair value of a share of common stock (for Year 2: $10,000 divided by $10.25 equals 976 shares). In this illustration, the remaining shares are released for compensation (for Year 2: 20,000 less 976 equals 19,024 shares).
- Shares are released from the suspense account for allocation to participants’ accounts based on a principal-plus-interest formula. The released shares are allocated to participant accounts the following year. Shares released and allocated follow.
- Income before employee stock ownership plan related charges is as follows.
- All interest cost and compensation cost are charged to expense each year.
- Excluding employee stock ownership plan shares, 1,000,000 shares are outstanding on average each year.
- Entity A follows the guidance in Subtopic 740-10.
- Entity A’s combined statutory tax rate is 40 percent each year.
- Entity A’s only book-tax differences are those associated with its employee stock ownership plan.
- No valuation allowance is necessary for deferred tax assets.
55-5 The following table sets forth Entity A’s employee stock ownership plan-related information. All amounts represent changes (credits in parentheses) in account balances.
55-7 Assuming Entity A
terminates its employee stock ownership plan at
the end of Year 2 (when the fair value of the
suspense shares is $540,000 [60,000 shares
multiplied by $9 per share], the unearned employee
stock ownership plan share balance is $600,000,
and the unpaid debt balance is $656,000), and
assuming the suspense shares are sold to pay down
the debt, Entity A would make the following
journal entry.
55-8 The following tables set forth Entity A’s tax (assuming no termination) and earnings per share (EPS) computations.
In this example, the leveraged ESOP affects the sponsor’s calculation of basic
EPS as a result of (1) the reduction in net income associated with the
interest and compensation expense recognized, net of the income tax
benefit, and (2) the increase in outstanding shares of common stock for
the shares of common stock released and allocated to participants in
each financial reporting period. As shares of common stock are released
from the collateral on the loan and allocated to participants,
compensation expense is recognized in an amount equal to the fair value
of the shares allocated and those shares become outstanding for the
calculation of basic EPS. Dividends paid on the shares of common stock
that have been allocated to participant accounts, which are paid in
additional shares of common stock, are recognized in retained earnings
and do not affect the numerator in the calculation of basic EPS.
However, these additional shares of common stock do increase the
outstanding shares of common stock in the denominator in the calculation
of basic EPS. Dividends paid on unallocated shares of common stock are
recorded as a reduction of debt and accrued interest and have no impact
on basic EPS. In this example, there is no incremental impact on the
sponsor’s calculation of diluted EPS on the basis of the terms of the
leveraged ESOP.
7.2.3.5.2 Common Stock Leveraged ESOP With an Indirect Loan
ASC 718-40-55-10 through 55-19 contain an example illustrating an ESOP that owns common stock and is leveraged through an indirect loan. In this example, the ESOP is used to fund the sponsor’s match of its 401(k) savings plan. The example does not take into account the impact of the leveraged ESOP on the sponsor’s EPS calculations. However, the EPS considerations are discussed after the example.
ASC 718-40
Case B: A Common-Stock Leveraged Employee Stock Ownership Plan Used to Fund the Employer’s Match of a 401(k) Savings Plan With an Indirect Loan
55-10 This Case illustrates a common stock leveraged employee stock ownership plan used to fund the employer’s match of a 401(k) savings plan with an indirect loan. On January 1, Year 1, Entity B established an employee stock ownership plan to fund the employer’s match of its savings plan. All of the assumptions are the same as those outlined in Case A for Entity A, except as follows:
- Entity B loaned its employee stock ownership plan $1,000,000 and concurrently obtained a related loan. The terms of both lending arrangements are the same as for Case A’s outside loan.
- Entity B uses shares released by the employee stock ownership plan to satisfy its matching obligation of 50 percent of voluntary employee contributions to the savings plan. The average fair value of the shares for each year is used to determine the number of shares necessary to satisfy the matching obligation.
- If the fair value of the shares released is less than Entity B’s matching obligation, Entity B contributes additional newly issued shares to the employee stock ownership plan to satisfy the remaining obligation.
- Shares used to replace dividends on allocated shares used to service debt do not count toward the employer’s match.
- The employee contributions, required employer match, and the number of shares needed to fund the employee match follow.
Note that the number of shares needed to satisfy the employer’s matching obligation is determined by dividing the matching obligation by the average fair value of a share of common stock (for Year 1: $200,000 divided by $10.75 [see above table for average fair values] equals 18,605 shares).
55-11 The 20,000 shares released each year based on debt service payments follow.
55-12 Cumulative share amounts follow.
55-13 Note that dividends on
top-up shares are paid in cash. Cumulative shares
released include top-up shares.
55-14 The following table sets forth Entity B’s employee stock ownership plan related information. All amounts represent changes (credits in parentheses) in account balances.
55-16 Note that the journal entry differs from Case A because Entity B receives an additional $10,000 deduction ($4,000 tax benefit) for the 976 top-up shares.
55-17 Assuming Entity B terminated its employee stock ownership plan at the end of Year 4 (when the fair value of the suspense shares is $240,000, the unearned employee stock ownership plan shares balance is $200,000, and the unpaid debt balance is $239,800), and assuming the employer buys back the suspense shares in an amount equal to the debt balance, there will be 17 suspense shares left, which must be allocated to participants. (In this Case the shares are used to partially satisfy the employer’s 401(k) matching obligation.) Entity B would make the following journal entry.
55-18 In this Case, Entity B’s taxes would be computed the same way as Case A. For Entity B the average number of employee stock ownership plan shares outstanding would be as follows.
55-19 This represents the cumulative numbers of shares released at the beginning of the year plus the end of the year (see the table in the preceding paragraph) divided by 2.
Although not specifically discussed in this example, the leveraged ESOP affects
the sponsor’s calculation of basic EPS as a result of (1) the reduction
in net income associated with the interest and compensation expense
recognized, net of the income tax benefit, and (2) the increase in
outstanding shares of common stock resulting from the release and
allocation of common stock to participants in each financial reporting
period. As shares of common stock are released from the collateral on
the loan and allocated to participants, compensation expense is
recognized in an amount equal to the fair value of the shares allocated
and those shares become outstanding for the calculation of basic EPS.
Compensation expense includes the fair value of the additional “top-up”
shares allocated to participants. Dividends paid on the shares of common
stock that have been allocated to participant accounts, which are paid
in additional shares of common stock, are recognized in retained
earnings and do not affect the numerator in the calculation of basic
EPS. However, these additional shares of common stock do increase the
outstanding shares of common stock in the denominator in the calculation
of basic EPS. Dividends paid on unallocated shares of common stock are
recorded as a reduction of debt and accrued interest and have no impact
on basic EPS. In this example, there is no incremental impact on diluted
EPS on the basis of the terms of the leveraged ESOP.
The total compensation expense recognized
(before the effect of income taxes) that reduces the numerator in the
calculation of basic EPS is as follows:
Dividends paid on allocated shares of common stock, regardless of whether they
are paid in cash or with additional shares of common stock, do not
affect the numerator in the calculation of EPS.
The following table shows the average shares of
common stock that are released and allocated to participants in each
financial reporting period and that become outstanding shares included
in the denominator for basic EPS on a weighted-average basis:8
7.2.3.5.3 Convertible Preferred Stock Leveraged ESOP With a Direct Loan
The example in ASC 718-40-55-21 through 55-29 illustrates an ESOP that owns convertible preferred stock and is leveraged through a direct loan. The example includes the impact on the sponsor’s basic and diluted EPS.
ASC 718-40
Case C: A Convertible-Preferred-Stock Leveraged Employee Stock Ownership Plan With a Direct Loan
55-21 This Case illustrates a convertible preferred stock leveraged employee stock ownership plan with a direct loan. On January 1, Year 1, Entity D established an employee stock ownership plan with convertible preferred stock. The assumptions are as follows:
- The borrowing, debt service, earnings, and tax assumptions are the same as those for Entity A outlined in Case A.
- On January 1, Year 1, the employee stock ownership plan used the proceeds of the debt to buy 80,000 shares of newly issued convertible preferred stock of Entity D for $12.50 per share.
- The preferred stock pays dividends quarterly at an annual rate of $1.25 per share ($100,000 each year for the employee stock ownership plan shares). Accordingly, in this Case the average fair value of the shares is used to determine the number of shares used to satisfy the employer’s obligation to replace dividends on allocated shares used for debt service.
- All dividends on employee stock ownership plan shares are used for debt service.
- The preferred stock is convertible into common stock at 1:1 ratio.
- Participants may not withdraw the convertible preferred stock from the employee stock ownership plan. When participants become eligible to withdraw shares from their account, they must either convert to common stock or redeem the preferred shares.
- The preferred stock has a guaranteed minimum redemption value of $12.50 per share, to be paid in shares of common stock.
- The preferred stock is callable at $13.00 per share.
- There is one vote per preferred share.
- The year-end and average fair values of a share of preferred stock (fair value is assumed to be greater than or equal to minimum value) follow.
55-22 The shares released each year follow.
55-23 Note that the number of shares released for dividends is determined by dividing the amount of dividends on allocated shares (16,000 multiplied by $1.25 in Year 2; 32,000 multiplied by $1.25 in Year 3; and so forth) by the average fair value of a share of preferred stock ($12.50 in Years 2 and 3). In this illustration the remaining shares are released for compensation (16,000 less 1,600 in Year 2, 16,000 less 3,200 in Year 3, and so forth).
55-24 Additional share information follows.
55-25 The following chart sets forth Entity D’s employee stock ownership plan related information. All amounts represent changes (credits in parentheses) in account balances.
55-26 The journal entries to reflect the accounting for Entity D’s employee stock ownership plan from inception through Year 2 are as follows.
55-27 The tax and EPS calculations for Entity D follow.
55-28 If-converted computation.
55-29 Computations for (1), (2), and (3) follow.
In this example, the leveraged ESOP affects the sponsor’s calculation of basic
EPS as follows:
-
Numerator — Income available to common stockholders is reduced by the interest and compensation expense recognized and dividends paid on shares of convertible preferred stock allocated to participants, net of the related income tax benefits. As shares of convertible preferred stock are released from the collateral on the loan and allocated to participant accounts, the sponsor reports compensation expense equal to the current fair value of the shares. Dividends on allocated shares, which are paid in additional shares of convertible preferred stock, are recognized in retained earnings and reduce income available to common stockholders by an amount equal to the fair value of the additional shares of convertible preferred stock allocated to participant accounts. Dividends paid on unallocated shares of convertible preferred stock are recorded as a reduction of debt and accrued interest and have no impact on the numerator.
-
Denominator — Because the ESOP holds convertible preferred stock that does not represent a participating security, basic EPS is unaffected because no shares of convertible preferred stock have been converted into shares of common stock.
The following additional adjustments are necessary for the sponsor’s calculation of diluted EPS:
- Numerator — Under the if-converted method, the following three adjustments are made to the numerator in the calculation of basic EPS: (1) an add-back equal to dividends paid during the year on allocated shares of convertible preferred stock, net of tax, under the assumption that those allocated shares were converted into common stock; (2) an add-back equal to the tax benefit that would have been received if the allocated shares of convertible preferred stock had been converted into shares of common stock and received dividends on the basis of the dividends paid on shares of common stock during the year; and (3) the additional compensation expense, net of tax, that would have been reported if the shares of convertible preferred stock had been converted into shares of common stock. All of these adjustments are calculated on the basis of the weighted-average outstanding shares during the period.
- Denominator — Under the if-converted method, incremental shares of common stock are included under an assumption that the allocated shares of convertible preferred stock have been converted into shares of common stock. The if-converted method is applied to allocated shares of convertible preferred stock on a weighted-average basis. In all years except the final year, the application of the if-converted method is based on an assumption of redemption in shares of common stock on the basis of the minimum stated amount of the convertible preferred stock because this approach is more dilutive than conversion at the stated conversion terms.
7.2.3.5.4 Convertible Preferred Stock Leveraged ESOP With an Employer Loan
The example in ASC 718-40-55-30 through 55-33 illustrates an ESOP that owns convertible preferred stock and is leveraged through an internal loan with the sponsor. In this example, the ESOP is used to fund the sponsor’s match of its 401(k) savings plan. The example includes the impact on the sponsor’s basic and diluted EPS.
ASC 718-40
Example 2: A Convertible, Preferred-Stock, Leveraged Employee Stock Ownership Plan Used to Fund a 401(k) Savings Plan With an Employer Loan
55-30 This Example
illustrates the guidance in paragraphs 718-40-25-7
through 25-17; 718-40-30-1 through 30-4;
718-40-35-1; 718-40-40-1 through 40-7; and
718-40-45-3 through 45-8 for a convertible
preferred stock leveraged employee stock ownership
plan used to fund a 401(k) savings plan with an
employer loan. This Example has the following
assumptions:
-
On January 1, Year 1, Entity E established a leveraged employee stock ownership plan with convertible preferred stock.
-
The employee stock ownership plan borrowed $1,000,000 from the employer at 10 percent for 5 years and used the proceeds to buy 80,000 shares of newly issued convertible preferred stock of Entity E for $12.50 per share.
-
Debt service is funded by cash contributions and dividends on employer stock held by the employee stock ownership plan.
-
Dividends on all of the original 80,000 shares held by the employee stock ownership plan are used for debt service.
-
Cash contributions are made at the end of each year.
-
The preferred stock pays dividends quarterly at an annual rate of $1.25 per share ($100,000 each year for the employee stock ownership plan’s shares). Accordingly, in this Example, the average fair value of the shares is used to determine the number of shares used to satisfy the employer’s obligation to replace dividends on allocated shares used for debt service.
-
The preferred stock is convertible at a 1:1 ratio into common stock.
-
Participants may not withdraw the convertible preferred stock from the employee stock ownership plan. When participants become eligible to withdraw shares from their account, they must either convert to common stock or redeem the preferred shares.
-
The preferred stock has a guaranteed minimum redemption value of $12.50 per share, to be paid in shares of common stock.
-
The preferred stock is callable at $13.00 per share.
-
There is one vote per preferred share.
-
The year-end and average fair values of a share of preferred stock (fair value is assumed to be greater than or equal to minimum value) follow.
-
Entity E uses shares released by the employee stock ownership plan to satisfy its matching obligation of 50 percent of voluntary employee contributions to the savings plan. The fair value of the shares at the end of each month is used to determine the number of shares necessary to satisfy the matching obligation. (Accordingly, in this Example, average fair values are used to determine the number of shares needed to satisfy the employer’s liabilities.)
-
If the fair value of the shares released is less than Entity E’s matching obligation, Entity E contributes additional newly issued shares (top-up shares) to the employee stock ownership plan to satisfy the remaining obligation. The top-up shares are issued at the end of the year. Dividends on the top-up shares are paid in cash.
-
Shares that replace dividends on allocated shares used to service debt do not count toward the employer’s match.
-
The employee contributions, required employer match, and the number of shares needed to fund the employee match follow.Note that the number of shares needed to satisfy the employer’s matching obligation is determined by dividing the matching obligation by the average fair value of a share of common stock (for Year 1: $200,000 divided by $12.50 equals 16,000 shares).
-
Principal and interest are payable in annual installments at the end of each year. Debt service is as follows.
-
Shares are released from the suspense account for allocation to participants’ accounts based on a principal-plus-interest formula. The released shares are allocated to participants’ accounts at the beginning of the following year. Shares are assumed to be released ratably throughout the year.
-
The shares released each year follow.Note that the number of shares released for dividends is determined by dividing the amount of dividends on allocated shares (12,481 multiplied by $1.25 in Year 2; 26,686 multiplied by $1.25 in Year 3, and so forth) by the average fair value of a share of preferred stock ($12.50 in Years 2 and 3). In this example, the remaining shares are released for compensation (14,205 less 1,248 in Year 2; 16,286 less 2,669 in Year 3, and so forth).
-
Additional share information follows.
-
The pre-employee stock ownership plan income, shares outstanding, and income tax assumptions are the same as for Example 1 (see paragraph 718-40-55-3).
55-31 The following chart sets forth Entity E’s employee stock ownership plan related information. All amounts represent changes (credits are in parentheses) in account balances.
55-32 The journal entries to reflect the accounting for Entity E’s employee stock ownership plan from inception through Year 2 are as follows.
In this example, the leveraged ESOP affects the sponsor’s calculation of basic
EPS as follows:
-
Numerator — Income available to common stockholders is reduced by the interest and compensation expense recognized and dividends paid on shares of convertible preferred stock allocated to participants, net of the related income tax benefits. As shares of convertible preferred stock are released from the collateral on the loan and allocated to participant accounts, the sponsor reports compensation expense equal to the current fair value of the shares (including the “top-up” shares). Dividends on allocated shares, which are paid in additional shares of convertible preferred stock, are recognized in retained earnings and reduce income available to common stockholders by an amount equal to the fair value of the additional shares of convertible preferred stock allocated to participant accounts. Dividends paid on unallocated shares of convertible preferred stock that are used to repay the debt between the sponsor and ESOP have no impact on the numerator.
-
Denominator — Because the ESOP holds convertible preferred stock that does not represent a participating security, there is no impact on basic EPS because no shares of convertible preferred stock have been converted into shares of common stock.
The following additional adjustments are necessary for the sponsor’s calculation of diluted EPS:
- Numerator — Under the if-converted method, the following three adjustments are made to the numerator in the calculation of basic EPS: (1) an add-back equal to dividends paid during the year on allocated shares of convertible preferred stock, net of tax, under the assumption that those allocated shares were converted into common stock; (2) an add-back equal to the tax benefit that would have been received if the allocated shares of convertible preferred stock had been converted into shares of common stock and received dividends on the basis of the dividends paid on shares of common stock during the year; and (3) the additional compensation expense, net of tax, that would have been reported if the shares of convertible preferred stock had been converted into shares of common stock. All of these adjustments are calculated on the basis of the weighted-average outstanding shares during the period.
- Denominator — Under the if-converted method, incremental shares of common stock are included under an assumption that the allocated shares of convertible preferred stock have been converted into shares of common stock. The if-converted method is applied to allocated shares of convertible preferred stock on a weighted-average basis. In all years except the final year, the application of the if-converted method is based on an assumption of redemption in shares of common stock on the basis of the minimum stated amount of the convertible preferred stock because this approach is more dilutive than conversion at the stated conversion terms.
7.2.4 Redeemable Shares Held by an ESOP
7.2.4.1 Scope of Temporary Equity Accounting
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(2) ASR 268 requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer. As noted in ASR 268, the Commission reasoned that “[t]here is a significant difference between a security with mandatory redemption requirements or whose redemption is outside the control of the issuer and conventional equity capital. The Commission believes that it is necessary to highlight the future cash obligations attached to this type of security so as to distinguish it from permanent capital.”
S99-3A(3) Although ASR 268
specifically describes and discusses preferred
securities, the SEC staff believes that ASR 268 also
provides analogous guidance for other redeemable
equity instruments including, for example, common
stock, derivative instruments, noncontrolling
interestsFN2, securities held by an
employee stock ownership planFN3, and
share-based payment arrangements with
employees.FN4 The SEC staff’s views
regarding the applicability of ASR 268 in certain
situations is described below.
____________________
FN2 The Master Glossary defines noncontrolling interest as “The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.” ASR 268 applies to redeemable noncontrolling interests (provided the redemption feature is not considered a freestanding option within the scope of Subtopic 480-10). Where relevant, specific classification and measurement guidance pertaining to redeemable noncontrolling interests has been included in this SEC staff announcement.
FN3 ASR 268 applies to equity securities held by an employee stock ownership plan (whether or not allocated) that, by their terms, can be put to the registrant (sponsor) for cash or other assets. Where relevant, specific classification and measurement guidance pertaining to employee stock ownership plans has been included in this SEC staff announcement.
FN4 As indicated in Section 718-10-S99, ASR 268 applies to redeemable equity-classified instruments granted in conjunction with share-based payment arrangements with employees. Where relevant, specific classification and measurement guidance pertaining to share-based payment arrangements with employees has been included in this SEC staff announcement.
ASC 480-10-S99-3A addresses the classification and measurement of redeemable
equity securities. ASC 480-10-S99-3A(3) indicates that the classification
and measurement guidance applies to shares of stock held by ESOPs, whether
nonleveraged or leveraged. ASC 480-10-S99-3A must be applied by SEC
registrants and in filings of financial statements by entities in the
process of registering securities with the SEC. The application of ASC
480-10-S99-3A by other nonpublic entities is optional. See Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity for
further discussion of which entities are subject to the guidance in ASC
480-10-S99-3A.
7.2.4.2 Classification of ESOP Shares Within Temporary Equity
7.2.4.2.1 Classification of Shares
ASC 480-10-S99-3A(2) requires that equity securities be classified in temporary equity if they are redeemable at the option of the holder or upon the occurrence of an event not solely within the issuer’s control. Thus, shares of common stock or convertible preferred stock held by an ESOP, whether nonleveraged or leveraged, that are redeemable at the option of the participant or upon any event outside the sponsor’s control must be classified within temporary equity.
The shares of stock held by an ESOP may meet the requirements for classification
in temporary equity because of various redemption features and terms. As discussed in EITF Issue 89-11, a sponsor of an ESOP is required to
provide participants with a put option on their shares of stock when those shares are not readily tradable. EITF Issue 89-11 states, in
part:9
Under federal income tax regulations, employer
securities (such as convertible preferred stock) that are held by
participants in an employee stock ownership plan (ESOP) and that are
not readily tradeable on an established market must include a put
option. The put option is a right to demand that the sponsor redeem
shares of employer stock held by the participant for which there is
no market for an established cash price. The employer may have the
option to issue marketable securities for all or a portion of that
option rather than to pay cash. The provisions of the ESOP may
permit the ESOP to substitute for the sponsor as buyer of the
employer stock; however, in no case can the sponsor require the ESOP
to assume the obligation for the put option.
ASC 718-40-25-2 also discusses this put option requirement and other situations
in which sponsors must repurchase shares of stock held by participants
that withdraw their shares. ASC 718-40-25-2 states:
Regardless of whether an employee stock ownership plan is leveraged
or nonleveraged, employers are required to give a put option to
participants holding employee stock ownership plan shares that are
not readily tradable, which on exercise requires the employer to
repurchase the shares at fair value. Public entity sponsors
sometimes offer cash redemption options to participants who are
eligible to withdraw traded shares from their accounts, which on
exercise requires the employer to repurchase the shares at fair
value. Employers shall report the satisfaction of such option
exercises as purchases of treasury stock.
In addition to the situations described above, shares of stock held by an ESOP may be redeemable as a result of various other features and terms, including, but not limited to, the following:
- Shares of convertible preferred stock held by the ESOP may be redeemable upon the occurrence of a change of control or another deemed liquidation event involving the sponsor.
- The sponsor may not have sufficient authorized and unissued shares of common stock to achieve the conversion of convertible preferred stock. For example, upon withdrawal, the holder may be entitled to receive a variable number of shares of common stock on the basis of a minimum stated value without any stated cap on the maximum number of shares of common stock that may need to be delivered. In the absence of a stated cap on the number of shares of common stock that must be delivered, the sponsor does not control the ability to deliver shares of common stock to satisfy such settlement requirements.
Connecting the Dots
The plan documents for an ESOP that holds common stock listed on a stock
exchange may contain a stated put option that becomes operable
only if the sponsor’s shares of common stock are no longer
readily tradable (e.g., the shares are delisted from the stock
exchange). In these situations, temporary equity classification
of the shares of common stock held by the ESOP is required
because it is not within an entity’s control to maintain the
readily tradable status of its common stock. However, when the
plan documents for an ESOP that holds common stock listed on a
stock exchange do not contain a stated put option in the event
that the sponsor’s shares of common stock are no longer readily
tradable, additional consideration is necessary. In these
situations, the sponsor does not control the ability to maintain
the listing of its shares of common stock on a stock exchange.
If the sponsor’s shares of common stock are delisted, they would
no longer be considered readily tradable and put options would
be issued to ESOP participants or their beneficiaries. However,
an entity is not required to classify those shares of common
stock in temporary equity if the sponsor has not yet legally
conveyed a put option to the ESOP participants or their
beneficiaries and if, upon receipt of a delisting notice or
another event that would cause the sponsor’s shares to no longer
be readily tradable, the sponsor has the unilateral ability to
(1) terminate the ESOP, (2) accelerate the vesting of all shares
of common stock held by the ESOP, and (3) distribute all the
shares of common stock held by the ESOP participants or their
beneficiaries before the sponsor’s shares become no longer
readily tradable. That is, if the holder of the shares does not
have a current redemption right and the sponsor controls the
ability to avoid the holder’s redemption of the shares of common
stock back to the sponsor under all circumstances (i.e., the
sponsor controls the ability to effect a plan termination, which
would avoid its requirement to provide a redemption option to
the holders), temporary equity classification of the common
stock held by the ESOP is not required. Note that entities must
carefully evaluate the facts and circumstances to determine
whether ESOP shares must be classified in temporary equity. As
part of this evaluation, it may be necessary to legally
interpret certain ERISA and IRC provisions related to the
requirement to provide put options on shares that are not
readily tradable.
In accordance with ASC 718-40-45-9, all shares held by a nonleveraged ESOP are
treated as outstanding except the suspense account shares of a pension
reversion ESOP, which are not treated as outstanding until they are
committed to be released for allocation to participant accounts (see
Section
7.2.2.1). Further, in accordance with ASC 718-40-45-3,
shares held by a leveraged ESOP that have been either allocated or
committed to be released (on the basis of the debt service payments)
should be considered outstanding (see Section 7.2.3.1). However, when
shares of stock held by an ESOP are redeemable (i.e., subject to a put
option or other redemption upon the occurrence of events outside the
sponsor’s control), the sponsor must classify all such shares in
temporary equity. The SEC’s guidance does not distinguish between
allocated and unallocated shares. See Section 7.2.4.2.2 for discussion
of classification of the contra-equity account related to unearned ESOP
shares. This guidance would also apply to nonleveraged ESOPs with
suspense pension reversion shares.
Connecting the Dots
For both nonleveraged and leveraged ESOPs, the vested status of shares of stock held by the ESOP is not relevant to the classification of such shares within temporary equity.
See Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity for
further discussion of the classification guidance in ASC 480-10-S99-3A.
7.2.4.2.2 Classification of Unearned ESOP Shares of Leveraged ESOP
When the outstanding shares of stock of a leveraged ESOP must be classified in temporary equity, it is also appropriate to classify all or a portion of the related contra-equity account for unearned ESOP shares in temporary equity. Although not codified, EITF Issue 89-11 states, in part:
The Task Force reached a consensus that when ASR 268 (as presented in Section 211 of the “Codification of Financial Reporting Policies”) requires some or all of the value of the securities to be classified outside of permanent equity, a proportional amount of the debit in the equity section of the sponsor’s balance sheet (sometimes described as loan to ESOP or deferred compensation), if any, should be similarly classified.
7.2.4.3 Initial and Subsequent Measurement
Under ASC 480-10-S99-3A, redeemable equity securities that are classified in temporary equity must be initially measured at fair value. This requirement is generally consistent with the initial measurement guidance related to shares of stock held by an ESOP, whether nonleveraged or leveraged. In addition, ASC 480-10-S99-3A requires that redeemable equity securities classified in temporary equity be subsequently remeasured to their redemption amounts in each financial reporting period unless redemption is contingent on an event outside the sponsor’s and holder’s control and it is not probable that the instrument will become redeemable.
ASC 480-10-S99-3A contains one exception to this general classification guidance that is relevant to shares of stock held by an ESOP that are classified in temporary equity. Paragraphs 12(b) and 16(b) of ASC 480-10-S99-3A and ASC 480-10-S99-4 describe this one exception to the general measurement requirements.
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: [Footnote omitted] . . .
b. For employee stock ownership plans where the cash redemption obligation relates only to a market value guarantee feature, the registrant may elect as an accounting policy to present in temporary equity either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation based on the fair value of the underlying equity securities at the balance sheet date.
S99-3A(16) The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .
b. For employee stock ownership plans where the cash redemption obligation relates only to a market value guarantee feature, the registrant may elect as an accounting policy to present in temporary equity either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation based on the fair value of the underlying equity securities at the balance sheet date.
SEC Observer Comment: Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an Employee Stock Ownership Plan
S99-4 ASR 268 (see also paragraph 480-10-S99-3A) requires that to the extent that there are conditions (regardless of their probability of occurrence) whereby holders of equity securities may demand cash in exchange for their securities, the sponsor must reflect the maximum possible cash obligation related to those securities outside of permanent equity. Thus, securities held by an ESOP (whether or not allocated) must be reported outside of permanent equity if by their terms they can be put to the sponsor for cash. With respect to ESOP securities where the cash obligation relates only to market value guarantee features, the SEC staff would not object to registrants only classifying outside of permanent equity an amount that represents the maximum cash obligation of the sponsor based on market prices of the underlying security as of the reporting date; accordingly, reclassifications of equity amounts would be required based on the market values of the underlying security. Alternatively, the SEC staff would not object to classifying the entire guaranteed value amount outside of permanent equity due to the uncertainty of the ultimate cash obligation because of a possible market value decline in the underlying security.
This exception should not be applied by analogy. For example, it would not apply when an amount other than the market value guarantee may need to be redeemed by the sponsor for cash or other assets and that redemption could occur upon any event outside the sponsor’s control. If the exception does not apply, the entire carrying amount of the ESOP’s outstanding redeemable shares of stock must be classified in temporary equity.
See Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity for
further discussion of the measurement guidance in ASC 480-10-S99-3A.
7.2.4.4 EPS Implications of Remeasurement Adjustments
ASC 480-10-S99-3A covers how the measurement adjustments to the redemption amounts of equity securities classified in temporary equity affect basic and diluted EPS. Generally, the EPS accounting implications are as follows:
- Common stock — If the common stock is redeemable at fair value, the redemption amount adjustments have no impact on basic or diluted EPS. If the common stock is redeemable at an amount other than fair value, the two-class method of EPS must be applied and the redemption amount adjustments are treated as dividends in the application of the two-class method. Redemption provisions related to shares of common stock held by an ESOP will often reflect fair value redemptions and have no impact on the calculation of basic and diluted EPS.
- Preferred stock — The redemption amount adjustments are treated as dividends in the calculation of EPS, regardless of whether the redemption is at a fair value or non–fair value amount. These deemed dividends reduce income available to common stockholders in the calculation of EPS.
Connecting the Dots
When an ESOP holds convertible preferred stock that is classified in temporary
equity on the sponsor’s balance sheet, in the calculation under the
if-converted method, the amount of any deemed dividends (along with
any tax benefits) from remeasurement adjustments that reduce income
available to common stockholders in the sponsor’s calculation of
basic EPS will need to be added back to the numerator as part of the
numerator adjustments discussed in Section 7.2.3.3.2.
See Sections 3.2.2.4 and 3.2.4.2 for further discussion of the EPS implications of remeasurement adjustments related to equity securities classified in temporary equity.
Footnotes
6
See definition of “employer securities”
in IRC Section 409(l).
7
An employer that terminates a defined
benefit pension plan may avoid part of the excise tax on an
asset reversion by transferring the assets to an existing or
newly created ESOP, which could be either leveraged or
nonleveraged. The reverted assets may be used either to
purchase shares of the employer stock or to retire existing
ESOP debt. Because the number of shares the ESOP acquires in
a pension plan reversion is usually more than the Internal
Revenue Service permits to be allocated to participant
accounts in a single year, some of the shares are held in a
suspense account until they are committed to be released in
future years for allocation to participant accounts. The
guidance in ASC 718-40 on shares held by leveraged ESOPs
applies to suspense account shares.
8
These calculations are based on the table in ASC
718-40-55-12.
9
Although not codified, the guidance in EITF Issue 89-11 is still relevant.
7.3 Other Compensation Arrangements
7.3.1 Profits Interests
Under ASC 718, awards granted as profits interests must be analyzed to determine
whether they represent a substantive class of
equity or whether they are more appropriately
classified as a performance bonus or
profit-sharing award. If a profits interest award
is determined not to represent a substantive class
of equity, it would not affect the calculation of
EPS (other than with respect to the impact of any
compensation expense on the numerator). If such an
award does represent a substantive class of
equity, in addition to the EPS considerations for
share-based payment awards discussed in Section
7.1, entities must consider how the
interest shares in the profits and losses of the
issuer because a profits interest may meet the
definition of a participating security to which
the two-class method of EPS must be applied. See
Section 5.3 for further discussion of
the definition of a participating security.
7.3.2 Common Stock Issued to Fund Certain Retirement Benefit Payments
ASC 710-10
Deferred Compensation — Rabbi Trusts
05-8 The Deferred
Compensation — Rabbi Trusts Subsections of this Subtopic
address the accounting for deferred compensation
arrangements where amounts earned by an employee are
invested in the stock of the employer and placed in a
rabbi trust. Certain of those plans allow the employee
to immediately diversify into nonemployer securities or
to diversify after a holding period (for example, six
months); other plans do not allow for diversification.
05-9 The deferred compensation obligation of some plans may be settled in any of the following:
- Cash, by having the trust sell the employer stock (or the diversified assets) in the open market
- Shares of the employer’s stock
- Diversified assets.
In other plans, the deferred compensation obligation may be settled only by delivery of the shares of the employer stock.
Deferred Compensation — Rabbi Trusts
45-3 For all of these types of plans, employer shares held by the rabbi trust shall be treated as treasury stock for earnings per share (EPS) purposes and excluded from the denominator in the basic and diluted EPS calculations. However, the obligation under the deferred compensation arrangement shall be reflected in the denominator of the EPS computation in accordance with the provisions of Section 260-10-45.
45-4 In accordance with paragraph 260-10-45-13, if an obligation is required to be settled by delivery of shares of employer stock (Plan A), those shares shall be included in the calculation of basic and diluted EPS. If the obligation may be settled by delivery of cash, shares of employer stock, or diversified assets (other than Plan A), those shares shall not be reflected in basic EPS but shall be included in the calculation of diluted EPS in accordance with paragraph 260-10-45-30 and paragraphs 260-10-45-45 through 45-46.
Some sponsors of defined benefit pension plans have issued common stock to
trusts established to fund future retirement payments. The common stock of the
sponsor is held until the rabbi trust is required to meet its retirement
obligations, at which time the shares are sold to the public. Because the
sponsor must consolidate the trust, the shares of common stock held by the trust
should not be considered outstanding in the calculation of EPS. Although those
transactions are not within the scope of ASC 718-40, the accounting is similar
to the accounting for shares of a leveraged ESOP that have not been committed to
be released, which are not considered outstanding shares. However, as discussed
in ASC 710-10-45-3 and 45-4, the sponsor’s obligation under the deferred
compensation arrangement should be reflected in the denominator in the EPS
calculation in accordance with ASC 260-10. If an obligation must be settled by
delivery of shares of employer stock (Plan A), those shares should be included
in the calculations of both basic and diluted EPS. If the obligation may be
settled by delivery of cash, shares of employer stock, or diversified assets
(other than Plan A), those shares would not be reflected in basic EPS but would
be included in the calculation of diluted EPS in accordance with the guidance in
ASC 260 on contracts that may be settled in cash or stock. See further
discussion in Section
4.7.
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.
Chapter 9 — Presentation and Disclosure
Chapter 9 — Presentation and Disclosure
9.1 Presentation
9.1.1 Required EPS Presentation on Face of Income Statement
ASC 260-10
Required EPS Presentation on the Face of the Income Statement
45-2 Entities with simple
capital structures, that is, those with only common
stock outstanding, shall present basic per-share amounts
for income from continuing operations and for net income
on the face of the income statement. All other entities
shall present basic and diluted per-share amounts for
income from continuing operations and for net income on
the face of the income statement with equal
prominence.
45-3 An entity that reports a discontinued operation in a period shall present basic and diluted per-share amounts for that line item either on the face of the income statement or in the notes to the financial statements.
45-4 The terms basic
EPS and diluted EPS are used to identify
EPS data to be presented and are not required to be
captions used in the income statement. There are no
explicit requirements for the terms to be used in the
presentation of basic and diluted EPS; terms such as
earnings per common share and earnings per
common share — assuming
dilution, respectively, are appropriate.
45-7 EPS data shall be presented for all periods for which an income statement or summary of earnings is presented. If diluted EPS data are reported for at least one period, they shall be reported for all periods presented, even if they are the same amounts as basic EPS. If basic and diluted EPS are the same amount, dual presentation can be accomplished in one line on the income statement.
ASC 270-10
Disclosure of Summarized Interim Financial Data by Publicly Traded Companies
50-1 Many publicly traded
companies report summarized financial information at
periodic interim dates in considerably less detail than
that provided in annual financial statements. While this
information provides more timely information than would
result if complete financial statements were issued at
the end of each interim period, the timeliness of
presentation may be partially offset by a reduction in
detail in the information provided. As a result, certain
guides as to minimum disclosure are desirable. (It
should be recognized that the minimum disclosures of
summarized interim financial data required of publicly
traded companies do not constitute a fair presentation
of financial position and results of operations in
conformity with generally accepted accounting principles
[GAAP].) If publicly traded companies report summarized
financial information at interim dates (including
reports on fourth quarters), the following data should
be reported, as a minimum: . . .
b. Basic and diluted earnings per share data
for each period presented, determined in
accordance with the provisions of Topic 260 . . .
.
ASC 260 requires an entity to present basic and diluted EPS (1) “with equal prominence” on the face of the income statement and (2) for each income statement period presented. Under ASC 270-10, the same requirement applies to interim periods.
The concept of materiality does not apply to the requirement to present both basic and diluted EPS on the face of the income statement. As noted in the Background Information and Basis for Conclusions of Statement 128, the FASB
considered that entities generally have to calculate diluted EPS to determine
that the basic and diluted EPS amounts are the same and that “requiring a dual
presentation at all times by all entities with complex capital structures places
all of the facts in the hands of users of financial statements at minimal or no
cost to preparers and gives users an understanding of the extent and trend of
potential dilution.”
An entity that reports a discontinued operation must present basic and diluted
EPS on the face of the income statement for income (loss) from continuing
operations and net income (loss) (or net income [loss] attributable to the
parent for an entity that has an NCI). Otherwise, an entity would only present
basic and diluted EPS for net income (loss) (or net income [loss] attributable
to the parent for an entity that has an NCI). See Sections 9.1.5 and 9.2.2.1 for further
discussion of the EPS presentation and disclosure requirements for discontinued
operations.
SEC Considerations
SEC Regulation S-X outlines the format and content required in financial reports filed with the SEC, including the presentation of EPS in annual reports and interim reports filed under the Exchange Act.
9.1.2 Multiple Classes of Common Stock
ASC 260-10-45-60B(d) requires presentation of basic and diluted EPS for each class of common stock. Therefore, an entity with multiple classes of common stock must present basic and diluted EPS for each class on the face of the income statement.
SEC Considerations
In numerous comment letters, the staff in the SEC’s Division of Corporation
Finance has indicated that an entity with multiple classes of common
stock that have the same amounts of basic and diluted EPS should either
(1) present basic and diluted EPS separately for each class of common
stock on the face of the income statement or (2) clearly state on the
face of the income statement that the amounts of basic and diluted EPS
are the same for each class of common stock.
9.1.3 “Tracking” or “Targeted” Stock
Some entities issue certain classes of stock characterized as “tracking” or
“targeted” stock to measure the performance of one of their business units,
activities, or assets. Under ASC 260-10-45-60B, such entities should use the
two-class method to determine EPS for each class of common stock. See the
previous section for further discussion of presentation considerations related
to multiple classes of common stock.
SEC Considerations
The SEC staff discourages an entity that has issued targeted stock from presenting complete financial statements of the business operations that pertain to the targeted stock, because investors may inaccurately conclude that their investment in such stock represents a direct investment in a legal entity. Rather, condensed financial statements that allow investors to fully understand the computation of earnings available for dividends are preferable to complete statements. A business that has issued targeted stock is also required to provide clear, cautionary disclosures.
Further, the SEC staff has indicated that EPS should not be shown in separate
financial statements of a business unit represented by the tracking
stock because the business unit did not issue the security. Rather, EPS
should only be presented and disclosed in the legal issuer’s
consolidated financial statements or along with its consolidated
information.
9.1.4 Participating Securities
ASC 260 does not require the presentation or disclosure of basic or diluted EPS for securities other than common stock. However, it also does not preclude the presentation of basic and diluted EPS for a participating security other than common stock. See Section 9.2.2.4 for further discussion of the required disclosures for participating securities and Section 9.2.3.3 for more information about the voluntary disclosure of EPS amounts for participating securities.
9.1.5 Discontinued Operations
ASC 205-20 addresses the accounting and presentation considerations related to
discontinued operations. As noted in ASC 260-10-45-3, an entity that reports a
discontinued operation must either present amounts of basic and diluted EPS for
discontinued operations on the face of the income statement or disclose these
amounts 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) on the face of the income
statement. See Sections
8.6.3.2.1 and 8.7 for further discussion of the presentation of EPS by an
entity that reports a discontinued operation.
9.1.6 Income or Loss Applicable to Common Stock
SEC Staff Accounting Bulletins
SAB Topic 6.B,
Accounting Series Release 280 — General Revision of
Regulation S-X: Income or Loss Applicable to Common
Stock [Reproduced in ASC 220-10-S99-5]
Facts: A
registrant has various classes of preferred stock.
Dividends on those preferred stocks and accretions of
their carrying amounts cause income applicable to common
stock to be less than reported net income.
Question: In ASR
280, the Commission stated that although it had
determined not to mandate presentation of income or loss
applicable to common stock in all cases, it believes
that disclosure of that amount is of value in certain
situations. In what situations should the amount be
reported, where should it be reported, and how should it
be computed?
Interpretive
Response: Income or loss applicable to common
stock should be reported on the face of the income
statement1 when it is materially
different in quantitative terms from reported net income
or loss2 or when it is indicative of
significant trends or other qualitative considerations.
The amount to be reported should be computed for each
period as net income or loss less: (a) dividends on
preferred stock, including undeclared or unpaid
dividends if cumulative; and (b) periodic increases in
the carrying amounts of instruments reported as
redeemable preferred stock (as discussed in Topic 3.C)
or increasing rate preferred stock (as discussed in
Topic 5.Q).
____________________
1 When a registrant reports
net income and total comprehensive income in one
continuous financial statement, the registrant must
continue to follow the guidance set forth in the SAB
Topic. One approach may be to provide a separate
reconciliation of net income to income available to
common stock below comprehensive income reported on a
statement of income and comprehensive income.
2 The assessment of
materiality is the responsibility of each registrant.
However, absent concerns about trends or other
qualitative considerations, the staff generally will not
insist on the reporting of income or loss applicable to
common stock if the amount differs from net income or
loss by less than ten percent.
SAB Topic 6.B requires SEC registrants to present “income or loss applicable to common stock” on the face of the income statement when the amount materially differs from net income or loss. However, the Codification does not define or otherwise refer to income or loss applicable to common stock. Rather, ASC 260 uses the defined term “income available to common stockholders” (emphasis added) and ASC 260 and ASC 810 refer to net income or loss “attributable to the parent” (although this latter term is not defined).
Since income available to common stockholders is the numerator in an entity’s
computation of EPS under ASC 260, the phrase “income or loss applicable to
common stock,” as referred to in SAB Topic 6.B. can be interpreted as the
equivalent of “income available to common stockholders.” That is, “income or
loss applicable to common stock” would be calculated as consolidated net income
or loss (or consolidated net income or loss attributable to the parent for
entities with an NCI) less preferred stock dividends and any other deductions
required by ASC 260 (see Chapter 3). An entity would compare this amount with
consolidated net income or loss (or consolidated net income or loss attributable
to the parent for entities with an NCI) to determine whether the difference is
material and would therefore need to be disclosed on the face of the income
statement.
When the difference between the aforementioned amounts is material (i.e., generally 10 percent or more, as indicated in footnote 2 of SAB Topic 6.B), an entity must present the numerator amount used in its EPS calculation on the face of the income statement; otherwise, the entity can only disclose this amount in the notes to the financial statements in accordance with ASC 260-10-50-1(a) (see Section 9.2.1). When the amount must be presented on the face of the income statement, an entity may use various terminology to present it (e.g., “income or loss applicable to common stock,” as referred to in SAB Topic 6.B, or “income available to common stockholders [of the parent],” as referred to in ASC 260).
SEC Considerations
SAB Topic 6.B does not address how entities with discontinued operations should
calculate “income or loss applicable to common stock.” However, because
ASC 260 requires presentation of basic and diluted EPS on the face of
the income statement for both income (loss) from continuing operations
and net income (loss), entities that present discontinued operations
should perform the calculations for income (loss) from continuing
operations available to common stockholders separately from those for
income (loss) available to common stockholders. If the difference in the
calculation (or calculations) constitutes a material difference as
described in SAB Topic 6.B, it should be presented on the face of the
income statement; otherwise, the amount(s) may only be disclosed.
9.2 Disclosure
This section details the EPS-related disclosure requirements under
U.S. GAAP (ASC 260 and other Codification topics) and is supplemented by discussion
of various EPS-related disclosures required by the SEC’s guidance. However, this
section does not comprehensively address all per-share disclosures that SEC
registrants must provide in filings made under the Securities Act or Exchange Act.
Accordingly, SEC registrants should consult SEC Regulations S-X and S-K, as well as
other relevant SEC guidance, regarding per-share disclosure requirements.
This section also discusses voluntary disclosures of other per-share
metrics. Appendix B
discusses pro forma EPS disclosures in SEC filings.
9.2.1 Disclosures Required by ASC 260
9.2.1.1 General
ASC 260-10
General
50-1 For each period for
which an income statement is presented, an entity
shall disclose all of the following:
- A reconciliation of the numerators and the denominators of the basic and diluted per-share computations for income from continuing operations. The reconciliation shall include the individual income and share amount effects of all securities that affect earnings per share (EPS). Example 2 (see paragraph 260-10-55-51) illustrates that disclosure. (See paragraph 260-10-45-3.) An entity is encouraged to refer to pertinent information about securities included in the EPS computations that is provided elsewhere in the financial statements as prescribed by Subtopic 505-10.
- The effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic EPS.
- Securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been antidilutive for the period(s) presented. Full disclosure of the terms and conditions of these securities is required even if a security is not included in diluted EPS in the current period.
50-1A Per-share amounts not
required to be presented by this Subtopic that an
entity chooses to disclose shall be computed in
accordance with this Subtopic and disclosed only in
the notes to financial statements; it shall be noted
whether the per-share amounts are pretax or net of
tax. (See paragraph 260-10-45-5.)
50-2 For the latest period
for which an income statement is presented, an
entity shall provide a description of any
transaction that occurs after the end of the most
recent period but before the financial statements
are issued or are available to be issued (as
discussed in Section 855-10-25) that would have
changed materially the number of common shares or
potential common shares outstanding at the end of
the period if the transaction had occurred before
the end of the period. Examples of those
transactions include the issuance or acquisition of
common shares; the issuance of warrants, options, or
convertible securities; the resolution of a
contingency pursuant to a contingent stock
agreement; and the conversion or exercise of
potential common shares outstanding at the end of
the period into common shares.
An entity that has multiple classes of common stock must
provide the disclosures required by ASC 260-10-50-1 and 50-2 separately for
each of these classes.
The example in ASC 260-10-55-51 and 55-52 below illustrates
the reconciliation of the numerators and denominators in the calculations of
basic and diluted EPS, which an entity is required to disclose under
ASC 260-10-50-1.
ASC 260-10
Example 2: EPS
Disclosures
55-51 This Example
illustrates the reconciliation of the numerators and
denominators of the basic and diluted EPS
computations for income from continuing operations
and other related disclosures required by paragraph
260-10-50-1 for Entity A in Example 1. Note that
Topic 718 has specific disclosure requirements
related to share-based compensation arrangements.
55-52 The following table
illustrates the computation of basic and diluted EPS
for the year ended 20X1.
Options to purchase 1,000,000
shares of common stock at $85 per share were
outstanding during the second half of 20X1 but were
not included in the computation of diluted EPS
because the options’ exercise price was greater than
the average market price of the common shares. The
options, which expire on June 30, 20Y1, were still
outstanding at the end of year 20X1.
SEC Considerations
SEC Regulation S-X, Rule 10-01(b)(2), states that in
interim reports, “[t]he basis of the earnings per share computation
shall be stated together with the number of shares used in the
computation.” This incremental disclosure requirement exists since
ASC 260 does not specifically require disclosure of the computation
of EPS in interim financial statements. Furthermore, SEC Regulation
S-K, Item 302(a)(1), requires disclosure of EPS information “when
there are one or more material retrospective changes to the
statements of comprehensive income for any of the quarters within
the two most recent fiscal years or any subsequent interim period
for which financial statements are included or are required to be
included by 17 CFR 210.3-01 through 210.3-20 (Article 3 of
Regulation S-X).”
9.2.1.2 Master Limited Partnerships
ASC 260-10
Master Limited
Partnerships
50-3 In the period in which a
dropdown transaction occurs that is accounted for
under the Transactions Between Entities Under Common
Control Subsections of Subtopic 805-50, a reporting
entity shall disclose in narrative format how the
rights to the earnings (losses) of the transferred
net assets differ before and after the dropdown
transaction occurs for purposes of computing
earnings per unit under the two-class method.
See Section 8.9.4 for a discussion of the accounting for
drop-down transactions by an MLP.
9.2.1.3 Shareholder Distributions and Changes in Capital Structure
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.
ASC 260-10-55-12 requires entities to disclose a
retrospective adjustment of previously reported amounts of basic and diluted
EPS as a result of a stock split, stock dividend, or reverse stock split.
While an entity is not specifically required to provide similar disclosures
when previously reported amounts of basic and diluted EPS have been
retrospectively adjusted as a result of a rights issue, the entity should
nevertheless furnish such disclosures.
As discussed in Section 8.2.1.1.2, an entity may file
a Form 10-K or Form 10-Q that does not reflect the impact on equity balances
and EPS of a stock dividend, stock split, or reverse stock split that has
been approved by an SEC registrant’s board of directors and declared before
the issuance of the financial statements (i.e., filing of Form 10-K or Form
10-Q), because the common stock does not yet trade on a post-split basis as
of the filing date (i.e., the stock dividend, stock split, or reverse stock
split has not been consummated as of the filing date). In these
circumstances, SEC registrants should provide relevant disclosures in the
notes to the financial statements, including the following:
-
The significant terms and other relevant facts and circumstances associated with the stock dividend, stock split, or reverse stock split, including the expected timing of the distribution.
-
The impact that the stock dividend, stock split, or reverse stock split will have on the authorized and issued shares of common stock (and other equity accounts affected).
-
The impact that the stock dividend, stock split, or reverse stock split will have on reported EPS.
SEC Considerations
Section 13500 of the FRM states, in part,
“Ordinarily, the staff would 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. Instead, the registration or proxy
statement may include selected financial data which 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 SEC 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 in a registration statement
or proxy statement.
9.2.1.4 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.
A correction of an error in previously reported financial
statements is subject to the disclosure guidance in ASC 260-10-55-15 and
ASC 250-10-50-7 through 50-11 (see Section 9.2.2.2).
9.2.2 Disclosures Required by Other Codification Topics
9.2.2.1 Discontinued Operations
ASC 205-20-50-5B and 50-5C, along with ASC 260-10-45-3 and
ASC 270-10-50-7(k), require entities to disclose the effects of discontinued
operations on EPS.
9.2.2.2 Accounting Changes and Error Corrections
ASC 250 describes four types of accounting changes: (1)
change in accounting principle, (2) change in accounting estimate, (3)
change in reporting entity, and (4) correction of an error in previously
issued financial statements (i.e., a restatement). Entities are required to
provide specific disclosures, including certain EPS-related disclosures, for
each of these types of changes. The table below summarizes the EPS-related
disclosure requirements in ASC 250.
Table
9-1
Type | Codification References | Disclosure Requirement(s) |
---|---|---|
Change in accounting principle | ASC 250-10-50-1(b)(2), ASC 250-10-50-1(c), and
ASC 250-10-50-3 | Entities should disclose the “effect of the
[retrospective application of the] change [in
accounting principle] on . . . any affected
per-share amounts for the current period and any
prior periods retrospectively adjusted.” Entities that recognize indirect
effects of a change in accounting principle should
disclose a “description of the indirect effects . .
. and the related per-share amounts” for the current
period and each prior period presented. “In the fiscal year in which a new
accounting principle is adopted, financial
information reported for interim periods after the
date of adoption shall disclose the effect of the
change on . . . related per-share amounts . . . for
those post-change interim periods.” |
Change in accounting estimate | ASC 250-10-50-4 | Entities should disclose the “effect on . . . any
related per-share amounts of the current period . .
. for a change in estimate that affects several
future periods.” “When an
entity effects a change in estimate by changing an
accounting principle, the disclosures required by
paragraphs 250-10-50-1 through 50-3 [for a change in
accounting principle] also are required.”
|
Change in reporting entity | ASC 250-10-50-6 | “When there has been a change in the reporting
entity, the financial statements of the period of
the change shall describe the nature of the change
and the reason for it [and] . . . the effect of the
change on . . . any related per-share amounts shall
be disclosed for all periods presented.” |
Correction of an error in previously issued
financial statements | ASC 250-10-50-7 and ASC 250-10-50-11 | Previously Issued Financial
Statements
When an entity has corrected an
error by restating financial statements, it should
disclose the “effect of the correction on . . . any
per-share amounts affected for each prior period
presented.” Prior Interim Periods of the
Current Fiscal Year
“In financial reports for the
interim period in which the adjustment [to prior
interim periods of the current fiscal year] occurs,
disclosure shall be made of . . . [t]he effect [of
the restatement on] related per-share amounts for
each prior interim period of the current fiscal year
[and the] related per-share amounts for each prior
interim period restated.” |
SEC Considerations
SEC Regulation S-K, Item 302(a)(1), and SEC
Regulation S-X, Rule 10-01(b)(7), require registrants to provide
additional disclosures when material retrospective prior-period
adjustments have been made in interim financial statements.
9.2.2.3 Convertible Debt
An entity that has entered into a lending arrangement on its
own shares in conjunction with a convertible debt issuance is subject to the
disclosure requirements in ASC 470-20-50-2A through 50-2C. For example,
ASC 470-20-50-2C may require an entity to disclose the number of common
shares related to a share-lending arrangement that would be reflected in
basic and diluted EPS if the counterparty to the arrangement were to
default. See Section
8.5 for further discussion of own-share lending arrangements.
9.2.2.4 Participating Securities
ASC 260-10-55-24 indicates that the participation rights of
a participating security must be disclosed in accordance with ASC 505-10,
regardless of whether undistributed earnings are allocated to the
participating security. In addition, when EPS is not separately presented
for participating securities, the amount of earnings allocated to such
securities should be disclosed, as a reconciling item, in the disclosures
related to the calculation of basic EPS. See also Sections 5.5.1.1 and 5.5.2.3 for
discussion of certain accounting policies related to participating
securities that should be disclosed.
9.2.2.5 Employee Stock Ownership Plans
An employer that sponsors an employee stock ownership plan
is subject to the disclosure requirements in ASC 718-40-50-1. Required
disclosures include a description of the treatment of ESOP plan shares in
EPS computations and the amount and treatment in EPS calculations of the tax
benefit related to dividends paid to any ESOP, if material. In complying
with the disclosure requirement in ASC 718-40-50-1(b), if an employer has
both grandfathered ESOP shares to which it continues to apply SOP 76-3 and
ESOP shares that are accounted for under ASC 718-40, the accounting policies
for both blocks of shares should be disclosed. An entity should also
separately disclose the EPS treatment for each block of shares. See
Section 7.2
for further discussion of the EPS implications of ESOPs.
9.2.2.6 Common-Control Business Combinations
ASC 805-50-50-2 and 50-3 contain disclosure requirements
applicable to the receiving entity in a transfer of net assets among
entities under common control. ASC 805-50-50-2 states that “[t]he nature of
and effects on [EPS] of nonrecurring intra-entity transactions involving
long-term assets and liabilities is not required to be eliminated under the
guidance in paragraph 805-50-45-3 but shall be disclosed.”
If the receiving entity is required to disclose EPS in its
separate financial statements and presents the common-control transfer as a
change in the reporting entity, EPS amounts must be recast to include the
earnings (or losses) of the transferred net assets (see further discussion
in Section
8.6.2). In addition to the disclosures required by
ASC 805-50, if the net assets transferred result in a change in the
reporting entity, the receiving entity must provide the disclosures required
by ASC 250-10-50-6, including the per-share disclosures discussed in
Table 9-1.
9.2.2.7 Reorganizations
ASC 852-10 requires that EPS be reported in accordance with
ASC 260. ASC 852-10-45-16 states, in part, that “[i]f it is probable that
the plan [of reorganization] will require the issuance of common stock or
common stock equivalents, thereby diluting current equity interests, that
fact shall be disclosed.”
9.2.2.8 Pro Forma Financial Information
See Appendix B for discussion of disclosures of supplemental pro
forma EPS.
9.2.3 Disclosures of Other Per-Share Metrics
9.2.3.1 General
ASC 260-10
Required EPS Presentation on
the Face of the Income Statement
45-5 Per-share amounts not
required to be presented by this Subtopic that an
entity chooses to disclose shall be computed in
accordance with this Subtopic and disclosed only in
the notes to financial statements; it shall be noted
whether the per-share amounts are pretax or net of
tax. (See paragraph 260-10-50-1A.)
45-6 Paragraph 230-10-45-3
prohibits reporting an amount of cash flow per
share.
Participating Securities
and the Two-Class Method
45-60 The two-class method is
an earnings allocation formula that treats a
participating security as having rights to earnings
that otherwise would have been available to common
shareholders but does not require the presentation
of basic and diluted EPS for securities other than
common stock. The presentation of basic and diluted
EPS for a participating security other than common
stock is not precluded.
Entities may wish to disclose per-share data beyond that
required by ASC 260. ASC 260-10-45-5 allows disclosure of such other
per-share amounts in the notes to the financial statements provided that the
per-share amounts are accompanied by disclosure of whether they are pretax
or net of tax. These other per-share amounts should be calculated in
accordance with ASC 260 and should not be presented on the face of the
income statement. Examples of other per-share amounts include dividends per
share and book value per share.
SEC Considerations
SEC registrants are required to disclose the amount
of dividends per share for each class of shares (as opposed to
common stock only) in both interim and annual reports filed under
the Exchange Act. Such amounts can be disclosed on the face of the
income statement or in the notes to the financial statements.
SEC registrants may also be required to disclose
certain metrics related to book value per share in certain filings.
For example, SEC Regulation S-K, Item 506, requires registrants to
disclose net tangible book value per share before and after a
distribution in certain IPOs of common stock when there is a
substantial disparity between the public offering price and the
offering price previously paid by officers, directors, promoters,
and affiliates. In addition, for business combinations subject to
SEC Regulation M-A, Item 1010(a)(4), entities must disclose book
value per share as of the date of the most recent balance sheet
presented.
With respect to other per-share amounts that an
entity wishes to disclose in filings with the SEC, including, but
not limited to, amounts related to book value per common share that
do not need to be disclosed under U.S. GAAP or the SEC’s guidance,
the entity must consider the SEC’s guidance on non-GAAP disclosures.
Any such disclosure that is not considered to involve a prohibited
non-GAAP financial measure should be accompanied by a description of
how such per-share amounts have been calculated.
9.2.3.2 Comprehensive Income
An entity may voluntarily disclose comprehensive income per
share in the notes to the financial statements, provided that:
- In the presentation, the per-share amount for comprehensive income is not more prominent than that for net income, which could potentially cause confusion.
- The disclosure is included in a comprehensive income footnote (it may not be included on the face of the income statement).
- The disclosure is provided for all periods presented.
- The calculation is consistent with the calculation of basic EPS in ASC 260 and is performed on a net-of-tax basis. (The calculation does not need to include a diluted EPS amount.)
9.2.3.3 Participating Securities
The presentation of basic and diluted EPS for participating
securities is permitted but not required under ASC 260-10-45-60. When an
entity chooses to disclose EPS for participating securities, the EPS amounts
should be calculated in accordance with ASC 260 and the entity should
disclose amounts of both basic and diluted EPS. When an entity has more than
one class of participating securities and chooses to disclose EPS, the
entity would generally disclose basic and diluted EPS for all classes of
participating securities. EPS amounts for participating securities should be
disclosed in the notes to the financial statements.
9.2.3.4 Non-GAAP Measures
C&DIs — Non-GAAP Financial
Measures
Question
102.05
Question:
While Item 10(e)(1)(ii) of Regulation S-K does not
prohibit the use of per share non-GAAP financial
measures, the adopting release for Item 10(e),
Exchange Act Release No. 47226, states that “per
share measures that are prohibited specifically
under GAAP or Commission rules continue to be
prohibited in materials filed with or furnished to
the Commission.” In light of Commission guidance,
specifically Accounting Series Release No. 142,
Reporting Cash Flow and Other Related Data,
and Accounting Standards Codification 230, are
non-GAAP earnings per share numbers prohibited in
documents filed or furnished with the
Commission?
Answer: No.
Item 10(e) recognizes that certain non-GAAP per
share performance measures may be meaningful from an
operating standpoint. Non-GAAP per share performance
measures should be reconciled to GAAP earnings per
share. On the other hand, non-GAAP liquidity
measures that measure cash generated must not be
presented on a per share basis in documents filed or
furnished with the Commission, consistent with
Accounting Series Release No. 142. Whether per share
data is prohibited depends on whether the non-GAAP
measure can be used as a liquidity measure, even if
management presents it solely as a performance
measure. When analyzing these questions, the staff
will focus on the substance of the non-GAAP measure
and not management’s characterization of the
measure. [May 17, 2016]
Although SEC Regulation S-K, Item 10(e), does not
specifically prohibit the disclosure of non-GAAP per-share financial
measures, such disclosures are not permitted by either U.S. GAAP or SEC
rules in certain instances, including the following:
- Cash flow per share and other per-share measures of liquidity — ASC 230-10-45-3 states that “[f]inancial statements shall not report an amount of cash flow per share. Neither cash flow nor any component of it is an alternative to net income as an indicator of an entity’s performance, as reporting per-share amounts might imply.” The SEC’s guidance in ASR 142 (FRR 202.04) contains a similar prohibition. Free cash flow is a liquidity measure and, therefore, per-share presentation is expressly prohibited. In addition, C&DI Question 103.02 notes that EBIT or EBITDA should not be presented on a per-share basis. The C&DI does not discuss the presentation of EPS related to adjusted EBIT or adjusted EBITDA. The determination of whether such presentation is acceptable may depend on the nature of the adjustment and whether the measure is clearly, in substance, a liquidity measure. See Section 4.4 of Deloitte’s Roadmap Non-GAAP Financial Measures and Metrics for further discussion.
- Per-share measures derived from prohibited non-GAAP measures — Registrants are not allowed to disclose a non-GAAP per-share measure that is derived from a prohibited non-GAAP financial measure. That is, the numerator in the non-GAAP per-share measure must be a non-GAAP measure permitted by SEC Regulation S-K, Item 10(e). See discussion below regarding the denominator.
Registrants may generally disclose other non-GAAP per-share
performance measures as long as they comply with other SEC
requirements for such measures (including the reconciliation to GAAP EPS).
C&DI Question 102.05 indicates that in a registrant’s discussion of its
operations, certain non-GAAP per-share performance measures “may be
meaningful.” However, the C&DI also specifies that the SEC staff may
challenge measures designated as performance measures that appear to be more
like liquidity measures (i.e., the staff will look at the substance of the
disclosure, not necessarily its form of characterization). When a
performance measure can be used as a liquidity measure, per-share
presentation of the measure is prohibited. See Section 3.2.2 of Deloitte’s Roadmap
Non-GAAP Financial
Measures and Metrics for more information.
Registrants are reminded to comply with all disclosure
requirements in Item 10(e), including the requirement to reconcile both the
numerator and denominator. A reconciliation of the denominator is not
necessary, however, if the denominator represents diluted shares in
accordance with ASC 260. If the denominator does not represent diluted
shares, registrants should use caution in presenting the measure and
consider whether the resulting measure could potentially be misleading. As
noted in footnote 49 of SEC Final Rule
33-8176, an SEC registrant should carefully consider
whether (1) it is appropriate to use any denominator other than diluted
shares calculated in accordance with ASC 260 and (2) the resulting measure
could potentially be misleading.
SEC Considerations
The SEC’s guidance on disclosure of non-GAAP
per-share amounts applies to both filings made under the Securities
Act or Exchange Act and documents furnished to the SEC. For example,
the SEC’s guidance on disclosure of non-GAAP per-share amounts must
be applied to non-GAAP information included in a press release,
which is furnished to the SEC in accordance with Form 8-K, Item
2.02.
In addition to disclosing non-GAAP per-share amounts,
entities may wish to explain the impact of certain one-time or unusual items
on reported EPS. An SEC registrant is generally permitted to disclose in
MD&A the individual effect of individual transactions or items on
GAAP-reported EPS amounts (e.g., the per-share impact of a significant
charge or gain) even if the presentation of EPS, excluding the individual
effect of the transaction or item, would otherwise be considered a
prohibited non-GAAP measure. This is consistent with the interpretive
response to Question 3 of SAB Topic 5.P.3, which indicates that
“[d]iscussions in MD&A and elsewhere which quantify the effects of
unusual or infrequent items on net income and earnings per share are
beneficial to a reader’s understanding of the financial statements and are
therefore acceptable.”
Below is an example of a disclosure of the EPS impact of a
nonrecurring gain.
SEC — Example Disclosure in MD&A
Included on Form 10-K
During fiscal 2017, the Company
completed the divestiture of four product
categories, which included 43 of the Company’s
beauty brands (“Beauty Brands”), including the
global salon professional hair care and color,
retail hair color, cosmetics and the fine fragrance
businesses, along with select hair styling brands.
The Beauty Brands had historically been part of the
Company’s Beauty reportable segment. The results of
the Beauty Brands are presented as discontinued
operations and, as such, are excluded from both
continuing operations and segment results for all
periods presented. Additionally, the Beauty Brands
balance sheet positions as of June 30, 2016 are
presented as held for sale in the Consolidated
Balance Sheets. The Company recorded an after-tax
gain on the final transaction of $[X] billion ($[Y]
per share), net of transaction and related
costs.
See Deloitte’s Roadmap Non-GAAP Financial Measures and
Metrics for more detailed discussion regarding the
disclosure of non-GAAP per-share amounts.
Appendix A — Differences Between U.S. GAAP and IFRS Accounting Standards
Appendix A — Differences Between U.S. GAAP and IFRS Accounting Standards
ASC 260 is the source of guidance on EPS under U.S. GAAP. IAS 33 is
the source of guidance on EPS under IFRS Accounting Standards. Although the methods
used to calculate basic and diluted EPS under IFRS Accounting Standards are similar
to those under U.S. GAAP, there are differences between the two sets of standards
with respect to how the methods are applied. The table below summarizes some of
these differences and is followed by an explanation of each difference.1
Subject
|
U.S. GAAP
|
IFRS Accounting Standards
|
---|---|---|
Scope
|
Presentation of EPS for investment companies
and wholly owned subsidiaries is not required.
|
There are no scope exceptions related to
presenting EPS for investment companies or wholly owned
subsidiaries.
|
Numerator (earnings)
|
Many accounting differences between U.S.
GAAP and IFRS Accounting Standards affect income available
to common shareholders. These differences will result in
differences in EPS.
|
See U.S. GAAP column.
|
Numerator (earnings): forward and option
contracts for which physical settlement by repurchase of
equity shares is or may be required
|
Other than forward contracts that must be
physically settled by repurchase of a fixed number of the
issuer’s equity shares, forward and option contracts for
which physical settlement by repurchase of equity shares is
or may be required are measured at fair value, with changes
in fair value recognized in earnings. Contracts measured at
fair value include (1) forward contracts to purchase
outstanding shares that give the counterparty (holder) the
option to elect either gross physical or net settlement and
(2) written options that give the counterparty the right to
put outstanding shares to the entity regardless of the form
of settlement (i.e., gross physical or net settlement).
|
Such contracts are liabilities measured on
the basis of the gross present value amount that the issuer
could be required to pay to repurchase its own equity
shares.
Because the accounting differs for these
contracts (except for forward contracts that must be
physically settled), basic and diluted EPS under IFRS
Accounting Standards will differ from basic and diluted EPS
under U.S. GAAP. This is because earnings (i.e., the
numerator) include changes in the fair value of these
contracts under U.S. GAAP, whereas the amount of earnings
under IFRS Accounting Standards is the change in the present
value of the amount that the issuer could be required to pay
to repurchase its own equity shares.
|
Treatment of mandatorily redeemable common
shares and forward contracts for which physical settlement
of a fixed number of shares for cash is required.
|
Basic EPS — Exclude the common shares
(and any related earnings effect) that are to be redeemed or
repurchased in the calculation of EPS. Apply the two-class
method of calculating EPS.
Diluted EPS — No further adjustment
to the numerator or the denominator is necessary.
|
Forward contracts for which physical
settlement of a fixed number of shares for cash is required:
Mandatorily redeemable common shares (basic
and diluted EPS):
These shares are typically excluded from the
denominator.
|
Treatment of mandatorily convertible
instruments
|
If the instrument is a participating
security, entities should apply the two-class method (the
results of doing so are similar to those achieved when an
entity considers the shares outstanding) to calculate basic
EPS and the more dilutive of the two-class method or
if-converted method to calculate diluted EPS.
If the instrument is not a participating
security, entities do not adjust the numerator or
denominator in calculating basic EPS. The if-converted
method is applied to calculate diluted EPS.
|
Ordinary shares that will be issued upon
conversion are considered outstanding in the calculation of
basic EPS from the date the contract is entered into,
irrespective of whether the contract is participating. The
result is similar to that achieved by applying the two-class
method, but the presentation differs. However, the EPS
result differs from that calculated under U.S. GAAP when the
instrument is not a participating security.
For diluted EPS, the shares are considered
outstanding and no adjustment is made to the numerator.
|
Application of the two-class method to
participating securities
|
The two-class method applies to
participating securities irrespective of whether they are
debt or equity instruments. ASC 260 includes detailed
guidance on such application.
|
The two-class method applies only to
participating securities that are equity instruments. It is
not required for participating debt instruments (e.g.,
participating convertible debt). There is no detailed
guidance on such application.
|
Denominator for diluted EPS: treasury stock
method — year-to-date calculation
|
For year-to-date diluted EPS, the number of
incremental shares included in the denominator is determined
by using a weighted average of the number of incremental
shares included in each quarterly calculation of diluted
EPS.
|
The number of incremental shares is
determined independently for each period presented. The
number of dilutive potential ordinary shares in the
year-to-date period is not a weighted average of the
dilutive potential ordinary shares included in each interim
calculation.
|
Denominator for diluted EPS: contingently
issuable shares
|
Shares whose issuance is contingent on the satisfaction of
certain conditions are included in the denominator for
diluted EPS if all necessary conditions have been met by the
end of the reporting period.
For year-to-date calculations, the number of
contingent shares included in the denominator of diluted EPS
is determined by weighting the interim periods.
|
Contingently issuable ordinary shares are included in the
denominator for diluted EPS if the conditions are met (i.e.,
have occurred).
Weighting interim periods in the
year-to-date calculation is not permitted. See “Denominator
for diluted EPS: treasury stock method — year-to-date
calculation” above.
|
Denominator for diluted EPS: contingently convertible
instruments
|
Shares issuable upon the conversion of a convertible
instrument that contains a market price trigger are included
in the calculation of diluted EPS regardless of whether the
market price trigger has been met as of the reporting date.
If a convertible instrument becomes convertible only if a
substantive non-market-based contingency is met, the shares
are included in the calculation of diluted EPS only if the
non-market-based contingency has been met as of the
reporting date.
|
Shares issuable upon the conversion of a contingently
convertible instrument are included in the calculation of
diluted EPS if the contingency has been met as of the
reporting date. The nature of the contingency that must be
met for conversion to occur is not relevant.
|
Denominator for diluted EPS: contracts that
may be settled in cash or shares
|
Inclusion of the shares in diluted EPS is
based on a presumption that the contract will be settled in
shares (if dilutive). The presumption of share settlement
may not be overcome except in the case of certain
share-based payment arrangements. Therefore, for contracts
that may be settled in cash or shares, if dilutive, share
settlement must be used in the calculation of diluted EPS,
regardless of whether the issuer or the holder has the right
to elect cash or shares.
When shares are included in the denominator
of diluted EPS and the contract is classified as an asset or
liability, an adjustment to the numerator may be required
for any changes in income or loss that would result if the
contract had been reported as an equity instrument.
|
For contracts that may be settled in cash or
ordinary shares, diluted EPS must be based on a presumption
that the contract will be settled in ordinary shares. The
presumption of share settlement may not be overcome.
Therefore, for contracts that may be settled in cash or
ordinary shares, if dilutive, share settlement must be used
in the calculation of diluted EPS, regardless of whether the
issuer or holder has the right to elect cash or shares.
When shares are included in the denominator
of diluted EPS and the contract either is classified as an
asset or liability, or has both an equity and a liability
component, the numerator must be adjusted for any changes in
profit or loss that would have resulted during the period if
the contract had been classified wholly as an equity
instrument.
|
Footnotes
1
The differences are based on a comparison of the
authoritative literature under U.S. GAAP and IFRS Accounting Standards and
do not necessarily include interpretations of such literature.
A.1 Scope
Under U.S. GAAP, ASC 260-10-15-3 provides a scope exception for investment
companies and wholly owned subsidiaries (see
Section 2.1 for more information).
Under IFRS Accounting Standards, IAS 33 does not
provide any scope exceptions for investment
entities or wholly owned subsidiaries. Thus, such
entities are required to present EPS if their
ordinary shares or potential ordinary shares are
traded in a public market or they have provided,
or are providing, a filing to a regulatory
organization to issue ordinary shares in the
public market. However, in accordance with
paragraph 4 of IAS 33, “[w]hen an entity presents
both consolidated financial statements and
separate financial statements,” the entity is
required to present EPS “only on the basis of the
consolidated information.”
A.2 Numerator (Earnings)
Accounting differences between U.S. GAAP and IFRS Accounting Standards affect
the amount of reported earnings (numerator) and,
consequently, result in EPS differences even if
the method used to calculate EPS is the same. For
example, the if-converted method is applied to
convertible securities for EPS purposes under both
U.S. GAAP and IFRS Accounting Standards, yet the
accounting (e.g., the initial and subsequent
measurement) for convertible securities often
differs. Under both sets of standards, a
calculation may have the same denominator (in the
absence of other denominator differences), but the
numerator may differ. This is because of the
numerous accounting differences between U.S. GAAP
and IFRS Accounting Standards that have an effect
on reported net earnings.
A.3 Numerator (Earnings): Forward and Option Contracts for Which Physical Settlement by Repurchase of Equity Shares Is or May Be Required
Under U.S. GAAP, ASC 480-10-30-7 and ASC 480-10-35-5 indicate that other than forward contracts that must be physically settled by purchase of a fixed number of outstanding shares, forward and option contracts for which physical settlement by repurchase of outstanding shares is or may be required are accounted for at fair value, with changes in fair value recognized in earnings. Such contracts include:
- Forward contracts to purchase outstanding shares that give the counterparty (holder) the option to elect either gross physical or net settlement.
- Written options that give the counterparty a right to put outstanding shares back to the issuer regardless of the form of settlement (i.e., gross physical or net settlement).
Under U.S. GAAP, no adjustments are made to the numerator or denominator for
basic EPS for these types of contracts. In
accordance with ASC 260-10-45-35 and 45-36, for
these types of contracts, diluted EPS is
calculated by using the reverse treasury stock
method to the extent that the effect is dilutive.
As discussed in Section 4.3, an
adjustment to the numerator is required under the
reverse treasury stock method because these
contracts are classified as assets or liabilities
for accounting purposes.
Under IFRS Accounting Standards, any contract that may result in a requirement
for the issuer to gross-settle a repurchase of its own equity instruments for cash
or other financial assets is classified as a financial liability. The financial
liability is measured at the gross present value amount that the issuer could be
forced to pay to repurchase its own equity. This treatment applies irrespective of
whether the amount to be repaid to repurchase the entity’s own equity is fixed or
variable or whether the counterparty has a choice between settling net and settling
gross. In addition, it applies to both forward purchase contracts and written put
options.
IFRS Accounting Standards are similar to U.S. GAAP in that no adjustments to the
numerator or denominator are made for basic EPS.
In accordance with paragraph 63 of IAS 33, diluted
EPS is calculated by using the reverse treasury
stock method to the extent the effect is dilutive.
Although the methods for calculating EPS are the
same under U.S. GAAP as they are under IFRS
Accounting Standards for both basic and diluted
EPS, EPS amounts may differ because of the
differences in the numerator.
A.4 Treatment of Mandatorily Redeemable Common Shares and Forward Contracts for Which Physical Settlement of a Fixed Number of Shares for Cash Is Required
A.4.1 Basic EPS
Under U.S. GAAP, an entity should exclude from the EPS denominator the shares
that are to be redeemed or repurchased and should apply the two-class method of
calculating EPS. See Section
3.2.4.3.1 for more information.
IFRS Accounting Standards do not provide basic EPS guidance on these
instruments. Under IFRS Accounting Standards:
-
For mandatorily redeemable common shares, the basic EPS treatment could be analyzed as follows:
-
Paragraph 10 of IAS 33 indicates that the denominator in the calculation of basic EPS is “the weighted average number of ordinary shares outstanding . . . during the period” (emphasis added). Paragraph 5 of IAS 33 states, in part, that an “ordinary share is an equity instrument that is subordinate to all other classes of equity instruments” (emphasis added). Thus, whether a mandatorily redeemable common share is included in the denominator in the calculation of basic EPS depends on whether the mandatorily redeemable common share (1) is considered an equity instrument and (2) is in the most subordinate class of equity instrument. Note that mandatorily redeemable common shares other than certain puttable shares are considered a liability under IFRS Accounting Standards.
-
-
For forward contracts that require physical settlement of a fixed number of equity shares for cash or other financial assets, IFRS Accounting Standards require presentation of a liability that is equal to the present value of the amount the issuer would be required to settle under the contract. Typically, under IFRS Accounting Standards, an entity would consider the equity shares that are to be repurchased outstanding in the calculation of basic EPS because the equity shares have not yet been repurchased as of the balance sheet date. The two-class method does not apply under IFRS Accounting Standards because this method is only applied under IAS 33 when the financial instrument is classified as an equity instrument.
A.4.2 Diluted EPS
Under U.S. GAAP, no further adjustment is made for diluted EPS. According to ASC
480-10-45-4, the entity simply carries forward the basic two-class method to
calculate diluted EPS. Under IFRS Accounting Standards, paragraph 63 of IAS 33
indicates that an entity would apply the reverse treasury stock method to the
forward repurchase agreement in the calculation of diluted EPS if the effect is
dilutive. Thus, U.S. GAAP differs from IFRS Accounting Standards with regard to
forward repurchase agreements because no further adjustment to the two-class
method result for basic EPS is made under U.S. GAAP, while under IFRS Accounting
Standards entities apply the reverse treasury stock method to the forward
repurchase agreement to the extent that the instrument is dilutive. The
application of the reverse treasury stock method can result in the addition of
incremental shares to the denominator.
Under IFRS Accounting Standards, there is no guidance on diluted EPS for
mandatorily redeemable common shares. However, the discussion of mandatorily
redeemable common shares in Section A.4.1 applies by extension to diluted EPS. That is, if
the mandatorily redeemable common shares are not ordinary shares or potential
ordinary shares as described in paragraph 5 of IAS 33, the shares are not
included in diluted EPS. Note that mandatorily redeemable common shares are
generally considered a liability under IFRS Accounting Standards.
A.5 Treatment of Mandatorily Convertible Instruments
The basic EPS implications of mandatorily convertible instruments are not
directly addressed in U.S. GAAP. However, if the
instrument is a participating security, an entity
should apply the two-class method of calculating
EPS. If the instrument is not a participating
security, there is no impact on basic EPS. For
diluted EPS purposes, if the instrument is a
participating security, the more dilutive of the
two-class method or if-converted method is
applied. If the instrument is not a participating
security, an entity would apply the if-converted
method to calculate diluted EPS if the effect is
dilutive See Sections 3.3.2.2
and 6.4 for more
information.
Under IFRS Accounting Standards, entities do not apply the two-class method to
mandatorily convertible instruments. Instead, paragraph 23 of IAS 33 indicates that
entities should consider the shares outstanding in the calculation of basic EPS and
diluted EPS from the date the contract is entered into.
If the instrument is participating, the EPS presentation required under U.S.
GAAP differs from that required under IFRS Accounting Standards, since under U.S.
GAAP an entity applies the two-class method to calculate both basic and diluted EPS,
while under IFRS Accounting Standards an entity considers the shares outstanding.
U.S. GAAP and IFRS Accounting Standards also differ when the instrument is not
participating. This is because under U.S. GAAP, entities make no adjustment to the
numerator or denominator in calculating basic EPS, while under IFRS Accounting
Standards the shares are considered to be outstanding, which increases the
denominator. The net result is that basic EPS will be lower under IFRS Accounting
Standards than under U.S. GAAP. For diluted EPS, results under U.S. GAAP will also
differ from those under IFRS Accounting Standards, since under U.S. GAAP an entity
will apply the if-converted method (thereby increasing outstanding shares and
removing from the numerator any income statement impact from the mandatorily
convertible instrument), while under IFRS Accounting Standards the shares are
considered outstanding and no adjustment is made to the numerator.
A.6 Application of the Two-Class Method to Participating Securities
A.6.1 Scope
Under ASC 260-10-45-59A through 45-70 in U.S. GAAP, the two-class method of
calculating basic EPS applies to both debt and
equity instruments if they are participating
securities. However, paragraphs A13 and A14 of IAS
33 under IFRS Accounting Standards only require
the application of the two-class method to
participating equity instruments. See Chapter
5 for more information.
A.6.2 Participating Convertible Securities
Under U.S. GAAP, participating convertible securities are included in the
calculation of basic EPS by using the two-class
method. This is the case for both participating
convertible preferred stock and participating
convertible bonds. Under ASC 260-10-45-60A,
entities are precluded from applying the
if-converted method in calculating basic EPS for
these instruments.
As discussed above, under IFRS Accounting Standards, entities do not apply the
two-class method to participating debt
instruments. Thus, the two-class method of
calculating basic EPS does not apply to
participating convertible debt under IFRS
Accounting Standards. An entity would not adjust
the numerator or denominator for these instruments
in calculating basic EPS. Whether the two-class
method applies to participating convertible
preferred stock depends on its balance sheet
classification. The two-class method does not
apply if the participating convertible preferred
stock is classified as a liability but does apply
if the stock is classified as equity.
A.6.3 Detailed Guidance
Under U.S. GAAP, ASC 260 contains detailed application guidance on applying the
two-class method of calculating EPS. There is no
similar detailed application guidance under IFRS
Accounting Standards. As a result, the two-class
method of calculating EPS may be applied
differently under U.S. GAAP than it is under IFRS
Accounting Standards.
A.7 Denominator for Diluted EPS: Treasury Stock Method — Year-to-Date Calculation
Under U.S. GAAP, the number of incremental shares included in quarterly diluted
EPS is calculated by using the average market prices during the three months in the
reporting period. ASC 260-10-55-3 indicates that “[f]or year-to-date diluted EPS,
the number of incremental shares [is determined by using] a year-to-date weighted
average of the number of incremental shares included in each quarterly diluted EPS
computation.” See Section
4.9.1 for more information.
Under IFRS Accounting Standards, paragraph 37 of IAS 33 states that the number
of incremental shares “shall be determined independently for each period presented.”
This is consistent with paragraph 29 of IAS 34, which states, in part, that “the
frequency of an entity’s reporting shall not affect the measurement of its annual
results.” Thus, in accordance with paragraph 37 of IAS 33, the number of dilutive
potential ordinary shares included in year-to-date calculations of diluted EPS is
the weighted average for the year-to-date period.
A.8 Denominator for Diluted EPS: Contingently Issuable Shares
The principles in U.S. GAAP are similar to those in IFRS Accounting
Standards with respect to the inclusion of contingently issuable shares in the denominator
for diluted EPS. However, the guidance on this topic may be applied differently under U.S.
GAAP than it is under IFRS Accounting Standards. Under U.S. GAAP, when common shares are
contingently issuable in the future on the basis of the attainment of a specified average
level of earnings, the calculation of the number of shares to be included in the denominator
for diluted EPS, if any, is based only on the actual amount of earnings achieved through the
reporting date (i.e., the entity assumes that the current amount of earnings will not change
and that, therefore, no additional earnings will be achieved in the future). Under IFRS
Accounting Standards, if the specified average level of earnings has been achieved as of the
reporting date, the entity assumes that the same level of earnings will be achieved through
the end of the contingency period. See Section 4.5.2.3 for more information about the application of ASC 260 to such
arrangements.
Under U.S. GAAP, ASC
260-10-45-49 states, “For year-to-date [EPS] computations, contingent shares shall be
included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the
computation of diluted EPS.” Under IFRS Accounting Standards, paragraph 52 of IAS 33 does
not permit entities to calculate year-to-date contingent shares by weighting the interim
periods. This is consistent with paragraph 29 of IAS 34, which states, in part, that “the
frequency of an entity’s reporting shall not affect the measurement of its annual results.”
See Section 4.9.4 for more
information about the application of ASC 260 to year-to-date calculations.
A.9 Denominator for Diluted EPS: Contingently Convertible Instruments
Under U.S. GAAP,ASC 260-10-45-43 and 45-44 address when the
if-converted method should be applied to convertible instruments that are
contingently convertible on the basis of a market price trigger. In accordance with
this guidance, as well as the guidance related to contingently issuable shares, the
if-converted method is applied to contingently convertible instruments as follows:
- If the instrument becomes convertible only if (1) a specified price of the entity’s common stock (i.e., a market price trigger) is achieved or (2) either a market-price trigger or some other non-market-based condition is met, the if-converted method should be applied, if dilutive, regardless of whether the conditions are met.
- If the instrument becomes convertible only if (1) a substantive non-market-based condition is met or (2) a market price trigger and some other substantive non-market-based condition are met, the if-converted method should be applied only if the non-market-based condition has been met as of the end of the reporting period.
See Section 4.4.3 for more information about
contingently convertible instruments.
Under IFRS Accounting Standards, paragraph 54 of IAS 33 indicates
that the calculation of diluted EPS is based on the number of ordinary shares that
would be issued if the market price at the end of the reporting period was the
market price at the end of the contingency period. Therefore, shares issuable upon
conversion of a convertible instrument that contains a market price trigger would be
included in the calculation of diluted EPS only if the market price trigger has been
achieved as of the reporting date. The same guidance would apply to convertible
instruments for which conversion is permitted only upon satisfaction of a
non-market-based condition.
A.10 Denominator for Diluted EPS: Contracts That May Be Settled in Cash or Shares
Under U.S. GAAP, for contracts that may be settled in cash or stock
— except for certain share-based payment arrangements — share settlement is presumed
and may not be rebutted if the effect of such settlement is dilutive, regardless of
whether such settlement is at the election of the issuer or the holder. Therefore,
share settlement must be used in the calculation of diluted EPS if the effect is
dilutive. In addition, if dilutive, the numerator in the calculation of diluted EPS
must be adjusted when the contract is classified as an asset or liability for
accounting purposes. See Section
4.7 for more information.
With one exception, the treatment of diluted EPS under IFRS
Accounting Standards is the same as that under U.S. GAAP for contracts that may be
settled in cash or shares. Paragraphs 58 and 60 of IAS 33 require an entity to
assume share settlement, regardless of whether the election to settle in cash or
shares is at the option of the issuer or the holder. Such a presumption cannot be
overcome if the effect of share settlement is dilutive. Unlike U.S. GAAP, IFRS
Accounting Standards do not provide an exception for share-based payment
arrangements in such circumstances.
Both U.S. GAAP and IFRS Accounting Standards address the need to
make a numerator adjustment when shares are included in the denominator of diluted
EPS and the contract is classified as an asset or liability. However, the U.S. GAAP
requirements on this topic may differ from those in IFRS Accounting Standards.
Paragraph 59 of IAS 33 indicates that such an adjustment is necessary if the
contract has both an equity and a liability component. ASC 260-10-45-46 only permits
such an adjustment if the contract is classified as an asset or liability. In
addition, there may be other situations in which an entity would be required to
adjust the numerator in calculating diluted EPS under IFRS Accounting Standards for
a contract that is classified as an asset or liability but would be prohibited from
doing so under U.S. GAAP.
Appendix B — Pro Forma EPS in SEC Filings
Appendix B — Pro Forma EPS in SEC Filings
B.1 Background
SEC Regulation S-X, Article 11, describes the circumstances in which pro forma
financial information should be presented in filings with the SEC, the form of such
presentation, and the guidance for an entity to consider in preparing such
information. Article 11 does not require that pro forma financial information be
presented in a Form 10-K or Form 10-Q filed under the Exchange Act or in the
historical financial statements of an acquired entity. Rather, the types of SEC
filings for which Article 11 may require entities to present pro forma financial
information, such as pro forma EPS, include the following:
-
Registration statements under the Securities Act.
-
Registration statements under the Exchange Act (i.e., a Form 10).
-
Form 8-K.
-
Proxy statements.
When Article 11 requires pro forma financial information in a filing with the
SEC, each pro forma income statement should include pro forma basic and diluted EPS
from continuing operations that applies to the controlling interest and that
reflects the transaction that has occurred, or whose occurrence is probable, for
which the pro forma financial information is needed.
In addition to Article 11, other SEC guidance and U.S. GAAP may also require the
presentation or disclosure of pro forma EPS in certain circumstances. Article 11
prohibits registrants from presenting pro forma financial information on the face of
their historical financial statements or in the accompanying notes except when such
presentation is required by U.S. GAAP. Therefore, pro forma EPS should only be
presented outside the historical financial statements unless the information must be
included or disclosed in the historical financial statements in accordance with U.S.
GAAP. Item 9.01 of Form 8-K also refers to certain requirements to present pro forma
financial information under Article 11 (see Section B.2.1.8). In all cases, pro forma EPS
amounts should be labeled as unaudited.
Section B.2
discusses SEC and other guidance (not all-inclusive) that may require an entity to
present or disclose pro forma EPS. Section B.3 addresses considerations related to the calculation of
pro forma EPS. Section
B.4 provides examples illustrating the calculation of pro forma EPS.
The discussion in this appendix includes references to the FRM (updated as of
December 2022).
In addition to this appendix, the following Deloitte Roadmaps contain guidance relevant to pro forma financial information:
B.2 Guidance Requiring Pro Forma EPS
This section includes excerpts from the SEC’s guidance and U.S. GAAP that refer
to the presentation or disclosure of pro forma EPS. The guidance below is not intended to
represent an all-inclusive list of the pro forma EPS information that should be disclosed in
documents filed with or furnished to the SEC. Entities are encouraged to consult with their
independent accountants and legal advisers in determining whether a transaction necessitates
the presentation or disclosure of pro forma EPS amounts.
B.2.1 Pro Forma EPS Required Under SEC Guidance
B.2.1.1 Article 11
SEC Regulation S-X, Article 11
210.11-01 — Presentation
Requirements.
(a) Pro forma financial information must be filed when any
of the following conditions exist:
(1) During the most recent fiscal year or subsequent
interim period for which a balance sheet is required by §210.3-01, a
significant business acquisition has occurred (for purposes of this section,
this encompasses the acquisition of an interest in a business accounted for
by the equity method);
(2) After the date of the most recent balance sheet filed
pursuant to §210.3-01, consummation of a significant business acquisition or
a combination of entities under common control has occurred or is
probable;
(3) Securities being registered by the registrant are to
be offered to the security holders of a significant business to be acquired
or the proceeds from the offered securities will be applied directly or
indirectly to the purchase of a specific significant business;
(4) The disposition of a significant portion of a business
either by sale, abandonment or distribution to shareholders by means of a
spin-off, split-up or split-off has occurred or is probable and such
disposition is not fully reflected in the financial statements of the
registrant included in the filing;
(5) [Reserved]
(6) Pro forma financial information required by §229.914
of this chapter is required to be provided in connection with a roll-up
transaction as defined in §229.901(c) of this chapter.
(7) The registrant previously was a part of another entity
and such presentation is necessary to reflect operations and financial
position of the registrant as an autonomous entity; or
(8) Consummation of other transactions has occurred or is
probable for which disclosure of pro forma financial information would be
material to investors.
210.11-02 — Preparation
Requirements.
(a) Form and content. . . .
(7)(ii)(A) If presented, Management’s Adjustments must be
presented in the explanatory notes to the pro forma financial information in
the form of reconciliations of pro forma net income from continuing
operations attributable to the controlling interest and the related pro
forma earnings per share data specified in paragraph (a)(9) of this section
to such amounts after giving effect to Management’s Adjustments. . . .
(9)(i) Historical and pro forma basic and diluted per share amounts based
on continuing operations attributable to the controlling interests and the
number of shares used to calculate such per share amounts must be presented
on the face of the pro forma condensed statement of comprehensive income and
only give effect to Transaction Accounting Adjustments and Autonomous Entity
Adjustments.
(9)(ii) The number of shares used in the calculation of
the pro forma per share amounts must be based on the weighted average number
of shares outstanding during the period adjusted to give effect to the
number of shares issued or to be issued to consummate the transaction, or if
applicable whose proceeds will be used to consummate the transaction as if
the shares were outstanding as of the beginning of the period presented.
Calculate the pro forma effect of potential common stock being issued in the
transaction (e.g., a convertible security), or the proceeds of which will be
used to consummate the transaction, on pro forma earnings per share in
accordance with U.S. GAAP or IFRS-IASB, as applicable, as if the potential
common stock were outstanding as of the beginning of the period
presented.
Pro forma financial information allows investors to understand and evaluate the impact of
a transaction, such as the acquisition or disposition of a business, by showing how that
transaction (or group of transactions) might have affected the registrant’s historical
financial position and results of operations if the transaction had occurred at an earlier
date. To prepare pro forma financial information, management must make the following two
types of adjustments:
- Transaction accounting adjustments — These adjustments reflect only the application of U.S. GAAP to the transaction (e.g., an acquisition or disposition). Such adjustments may include, for example, the recognition of goodwill and intangible assets and adjustments of assets and liabilities to fair value on the balance sheet, as well as the related impacts on the statement of comprehensive income, under the assumption that the balance sheet adjustments were made as of the beginning of the fiscal year presented. For transactions involving the issuance of common stock or potential common stock, an entity may need to make an adjustment to increase the weighted-average number of shares included in basic and diluted EPS.
- Autonomous entity adjustments — These adjustments, which are only required if the registrant was previously part of another entity, reflect incremental expense or other changes necessary to reflect the registrant’s financial condition and results of operations as if it were a separate stand-alone entity. For example, if a public entity plans to distribute a portion of its business to its shareholders as a separate public company (e.g., spin-off), its pro forma financial statements must include autonomous entity adjustments to reflect the incremental costs expected to be incurred as if it were a separate stand-alone entity. If the distributed entity’s historical financial statements include allocated overhead costs of $5 million but the entity expects such costs to be $8 million when it is a stand-alone entity, it would be required to make a $3 million adjustment for additional overhead costs.
Article 11 requires registrants to provide separate columns in their pro forma financial
information for (1) historical financial information, (2) transaction accounting
adjustments, and (3) autonomous entity adjustments. Such information must also contain a
pro forma total, including the (1) amounts of pro forma basic and diluted EPS from
continuing operations that are attributable to the controlling interests and (2) number of
shares used to calculate such amounts. The amounts of pro forma EPS must be presented on
the face of the pro forma statement of comprehensive income, and such calculations must
give effect to both transaction accounting adjustments and autonomous entity adjustments,
if applicable. Article 11 discusses the disclosures registrants must provide regarding pro
forma financial information.
The number of shares used in the calculations of pro forma EPS is determined on the basis
of the weighted-average number of shares outstanding during the period, adjusted by the
number of shares issued or to be issued to consummate the transaction or whose proceeds
will be used to consummate the transaction as if the shares were outstanding as of the
beginning of the period presented. Similarly, potential common shares issued in the
transaction (or the proceeds of which will be used to consummate the transaction) are
treated as if they were outstanding as of the beginning of the period presented.
In addition to the required adjustments noted above, Article 11 gives
registrants the option of presenting, in the explanatory notes to the pro forma financial
information, adjustments reflecting synergies and dis-synergies management identified when
evaluating whether to consummate an acquisition. Management’s adjustments may provide
insight into the potential effects of an acquisition as well as the plans that management
expects to execute after the acquisition (these plans may take forward-looking information
into account). To the extent that such adjustments do not qualify as transaction
accounting or autonomous entity adjustments, they may include, but are not limited to,
closing facilities, discontinuing product lines, and terminating employees. A registrant
that presents synergies must also present any related dis-synergies.
Connecting the Dots
An entity must always make transaction accounting adjustments and autonomous entity
adjustments (if applicable) when preparing pro forma financial information.
Management’s adjustments are always optional and may only “be presented in the
explanatory notes to the pro forma financial information” in the form of
reconciliations of (1) pro forma net income from continuing operations attributable to
the controlling interest and the related pro forma EPS data to (2) such amounts after
the effect of management’s adjustments is taken into account.
The preparation, presentation, and disclosure of pro forma financial
information by smaller reporting companies (SRCs) must substantially comply with Article
11. Under Article 11, pro forma EPS must be presented outside the financial statements and
therefore should be presented as unaudited information.
B.2.1.2 Allocation of Expenses and Related Disclosure in Financial Statements of Subsidiaries, Divisions, or Lesser Business Components of Another Entity
SEC Staff Accounting Bulletins
SAB Topic 1.B.1, Costs Reflected in
Historical Income Statements [Reproduced in ASC 220-10-S99-3]
Facts: A company (the registrant)
operates as a subsidiary of another company (parent). Certain expenses
incurred by the parent on behalf of the subsidiary have not been charged to
the subsidiary in the past. The subsidiary files a registration statement
under the Securities Act of 1933 in connection with an initial public
offering. . . .
Question 3: What are the staff’s
views with respect to the accounting for and disclosure of the subsidiary’s
income tax expense?
Interpretive Response: Recently, a
number of parent companies have sold interests in subsidiaries, but have
retained sufficient ownership interests to permit continued inclusion of the
subsidiaries in their consolidated tax returns. The staff believes that it
is material to investors to know what the effect on income would have been
if the registrant had not been eligible to be included in a consolidated
income tax return with its parent. Some of these subsidiaries have
calculated their tax provision on the separate return basis, which the staff
believes is the preferable method. Others, however, have used different
allocation methods. When the historical income statements in the filing do
not reflect the tax provision on the separate return basis, the staff has
required a pro forma income statement for the most recent year and interim
period reflecting a tax provision calculated on the separate return
basis.1
____________________
1 FASB ASC paragraph 740-10-30-27 (Income Taxes
Topic) states: “The consolidated amount of current and deferred tax expense
for a group that files a consolidated tax return shall be allocated among
the members of the group when those members issue separate financial
statements. . . . The method adopted . . . shall be systematic, rational,
and consistent with the broad principles established by this Subtopic. A
method that allocates current and deferred taxes to members of the group by
applying this Topic to each member as if it were a separate taxpayer meets
those criteria.”
SAB Topic 1.B.2, Pro Forma Financial
Statements and Earnings per Share [Reproduced in ASC 205-10-S99-7]
Question: What disclosure should
be made if the registrant’s historical financial statements are not
indicative of the ongoing entity (e.g., tax or other cost sharing agreements
will be terminated or revised)?
Interpretive Response: The
registration statement should include pro forma financial information that
is in accordance with Article 11 of Regulation S-X and reflects the impact
of terminated or revised cost sharing agreements and other significant
changes.
SAB Topic 1.B.1 specifically addresses the presentation of pro forma financial
information in situations in which the financial statements of a subsidiary do not
reflect income taxes on a separate-return basis. Footnote 37 in SAB Topic 5.T also
refers to SAB Topic 1.B.1 and states:
[I]n some circumstances it is
necessary to reflect, either in the historical financial statements or a pro forma
presentation (depending on the circumstances), related party transactions at amounts
other than those indicated by their terms. Two such circumstances are addressed in
Staff Accounting Bulletin Topic 1.B.1, Questions 3 and 4. Another example is where the
terms of a material contract with a related party are expected to change upon the
completion of an offering (i.e., the principal shareholder requires payment for
services which had previously been contributed by the shareholder to the
company).
Since SAB Topic 1.B.2 requires an SEC registrant to prepare pro forma financial
information in accordance with Article 11, the pro forma financial information must
include pro forma EPS, which should be labeled as unaudited. In accordance with Article
11, this information must be presented outside the financial statements.
B.2.1.3 Distributions From the Proceeds of an Offering
SEC Staff Accounting Bulletins
SAB Topic 1.B.3, Other Matters
[Reproduced in ASC 855-10-S99-1]
Question: What is the staff’s
position with respect to dividends declared by the subsidiary subsequent to
the balance sheet date?
Interpretive Response: The staff
believes that such dividends either be given retroactive effect in the
balance sheet with appropriate footnote disclosure, or reflected in a pro
forma balance sheet. In addition, when the dividends are to be paid from the
proceeds of the offering, the staff believes it is appropriate to include
pro forma per share data (for the latest year and interim period only)
giving effect to the number of shares whose proceeds were to be used to pay
the dividend. A similar presentation is appropriate when dividends exceed
earnings in the current year, even though the stated use of proceeds is
other than for the payment of dividends. In these situations, pro forma per
share data should give effect to the increase in the number of shares which,
when multiplied by the offering price, would be sufficient to replace the
capital in excess of earnings being withdrawn.
While the facts in SAB Topic 1.B.3 apply to a subsidiary of a parent company,
the SEC staff’s guidance also requires an entity to present pro forma EPS when the
proceeds from an offering will fund, or will be presumed to fund, distributions to the
entity’s promoters, owners, and shareholders. Sections 3420 and 7340 of the FRM provide
the SEC staff’s views on situations in which such distributions occur at or before the
closing of an IPO or another offering of securities.
FRM Topic 3
3420 Distributions to Promoters/Owners
at or Prior to Closing of an IPO [SAB Topic 1B.3]
3420.1 If a planned distribution
to owners, regardless of whether it has been declared or whether it will be
paid from proceeds, is not reflected in the latest balance sheet but would
be significant relative to reported equity, a pro forma balance sheet
reflecting the distribution accrual (but not giving effect to the offering
proceeds) should be presented alongside the historical balance sheet in the
filing.
3420.2 If a distribution to
owners, regardless of whether it is declared or whether it is reflected
already in the balance sheet, is to be paid out of proceeds of the offering
rather than from the current year’s earnings, pro forma per share data
should be presented (for the latest year and interim period only) giving
effect to the number of shares whose proceeds would be necessary to pay the
dividend (but only the amount that exceeds current year’s earnings) in
addition to historical EPS. The number of shares to be added to the
denominator for purposes of pro forma per share data should not exceed the
total number of shares to be issued in the offering. For purposes of this
interpretation, a dividend declared in the latest year would be deemed to be
in contemplation of the offering with the intention of repayment out of
offering proceeds to the extent that the dividend exceeded earnings during
the previous twelve months.
FRM Topic 7
7340 Offering Proceeds
7340.1 In addition to historical
EPS, if a material portion of the proceeds of an offering will be
distributed to shareholders, present pro forma EPS for the latest year and
interim period reflecting dilution equivalent to the number of shares whose
proceeds will be used to pay dividends.
7340.2 Even if the distribution is
not clearly to be paid from offering proceeds, pro forma EPS is required if
the distribution exceeds current year’s earnings.
As indicated in paragraph 3420.2 of the FRM, if a distribution to
owners/shareholders “is to be paid out of proceeds of the offering rather than from the
current year’s earnings,” an entity should present pro forma EPS, for the latest fiscal
year and interim period, to reflect this distribution. In accordance with Article 11,
this information must be presented outside the financial statements. Proceeds from an
offering that will be used for general corporate purposes should not result in the
inclusion of incremental common shares in the denominator of pro forma EPS amounts.
However, the SEC staff presumes that dividends declared before an IPO or offering are in
contemplation of the IPO or offering (and therefore are paid out of the offering
proceeds) if those distributions exceed the entity’s earnings during the preceding 12
months. Any pro forma EPS presented as a result of these requirements should be labeled
as unaudited.
Connecting the Dots
This unaudited pro forma presentation is required even if the payment of a dividend to owners/shareholders is not mentioned as a stated use of proceeds in the registration statement.
See Section B.3.2 for computational guidance related to distributions from proceeds of an offering. See Example B-1 for an illustration of this pro forma requirement.
B.2.1.4 Changes in Capitalization at or Before Closing of an IPO
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.
3430.2 If terms of outstanding
equity securities will change subsequent to the date of the latest balance
sheet and the new terms result in a material reduction of permanent equity
or, if redemption of a material amount of equity securities will occur in
conjunction with the offering, the filing should include a pro forma balance
sheet (excluding effects of offering proceeds) presented alongside of the
historical balance sheet giving effect to the change in capitalization.
3430.3 If the conversion of
outstanding securities will occur subsequent to the latest balance sheet
date and the conversion will result in a material reduction of earnings per
share (excluding effects of offering), pro forma EPS for the latest year and
interim period should be presented giving effect to the conversion (but not
the offering).
In connection with an IPO, certain outstanding securities, such as convertible
securities or restricted share-based units, may be converted into common stock of the
entity. To provide financial statement users with transparent disclosure regarding a
prospective SEC registrant’s potential operating performance after such anticipated
changes in capitalization, paragraph 3430.3 of the FRM requires an entity to present pro
forma EPS when outstanding securities will be converted after the latest balance sheet
date and this conversion will cause a material reduction in EPS (excluding the effects
of the offering). In accordance with Article 11, this information must be presented
outside the financial statements and is unaudited.
The following decision tree illustrates the
application of this guidance:
A common situation involving a change in capitalization for which the
presentation of pro forma EPS is required is the mandatory conversion of preferred stock
into common stock in conjunction with an IPO. While not a reduction of equity, pro forma
EPS must be presented for this type of conversion if the conversion would materially
reduce EPS. In this case, pro forma basic EPS includes the preferred stock on an
as-converted basis.
FRM Topic 3
3620 Filings Subsequent to an IPO
Pro forma basic EPS reflecting the conversion of preferred
stock into common stock at the IPO date should not be presented in financial
statements issued subsequent to the IPO.
In Section 3620 of the FRM, the SEC staff indicates that the pro forma basic EPS
that was provided in the filing for an IPO should not be included in the registrant’s
financial statements filed under the Exchange Act after the IPO. This view is consistent
with Article 11, which requires that all pro forma financial information be presented
outside the financial statements.
See Section B.3.3 for computational guidance related to changes in capitalization at or before the closing of an IPO. See Example B-2 for an illustration of this pro forma requirement.
B.2.1.5 Use of Proceeds From Offering of Convertible Securities to Extinguish Preferred Stock or Debt
SEC Staff Accounting Bulletins
SAB Topic 3.A, Convertible
Securities
Facts: Company B proposes to file
a registration statement covering convertible securities.
Question: In registration, what
consideration should be given to the dilutive effects of convertible
securities?
Interpretive Response: In a
registration statement of convertible preferred stock or debentures, the
staff believes that disclosure of pro forma earnings per share (EPS) is
important to investors when the proceeds will be used to extinguish existing
preferred stock or debt and such extinguishments will have a material effect
on EPS. That disclosure is required by Article 11, Rule 11-01(a)(8) and Rule
11-02(b)(7) of Regulation S-X, if material.
As with the requirement to present pro forma EPS for changes in capital
structure in conjunction with an IPO, SAB Topic 3.A states that when an entity registers
convertible preferred stock or debentures and will use the proceeds from the offering to
extinguish existing preferred stock or debt, the entity should disclose pro forma EPS
outside the financial statements in the registration statement if the resulting effect
on EPS will be material. Although SAB Topic 3.A only specifically addresses the offering
of convertible securities, the SEC staff’s view would extend to situations in which an
entity is offering common securities to extinguish existing preferred stock or debt.
See Section B.3.4 for computational guidance related to proceeds from offerings of convertible securities to extinguish preferred stock or debt. See Examples B-3 through B-5 for illustrations of this pro forma requirement.
B.2.1.6 Changes in Tax Status in Conjunction With an IPO
FRM Topic 3
3410 Sub-Chapter S Corporations and
Partnerships
3410.1 If the issuer was formerly
a Sub-Chapter S corporation (“Sub-S”), partnership or similar tax exempt
enterprise, pro forma tax and EPS data should be presented . . . for the
periods identified below:
-
If necessary adjustments include more than adjustments for taxes, limit pro forma presentation to latest fiscal year and interim period
-
If necessary adjustments include only taxes, pro forma presentation for all periods presented is encouraged, but not required.
3410.2 In filings for periods
subsequent to becoming taxable, pro forma presentations reflecting tax
expense for earlier comparable periods should continue to be presented for
periods prior to becoming taxable and for the period of change if the
registrant elects to present pro forma information for all periods pursuant
to 3410.1(b). Such pro forma presentations should continue to calculate the
pro forma tax expense based on statutory rates in effect for the earlier
period.
3410.3 Undistributed earnings or
losses of a Sub-S registrant should be reclassified to paid-in capital in
the pro forma statements. [SAB Topic 4B] Similarly, undistributed earnings
or losses of partnerships should be reclassified to paid-in capital in the
pro forma statements. That presentation assumes a constructive distribution
to the owners followed by a contribution to the capital of the corporate
entity.
3410.4 Sub-S registrants or
partnerships that pay distributions to promoter-owners at the close or
effectiveness with proceeds of the offering (rather than out of retained
earnings) should consider the pro forma presentations specified in Section
3430.3.
As discussed in Section 3410 of the FRM, if an entity is organized as a
nontaxable entity (e.g., partnerships, LLCs, S corporations) and expects to be converted
to a taxable entity (e.g., a C corporation) in conjunction with an IPO, pro forma income
taxes and EPS should be presented to reflect the impact of the conversion. See Section B.3.5 for computational
guidance related to changes in tax status in conjunction with an IPO.
B.2.1.7 Other Guidance
In addition to the FRM, entities should consult other guidance (e.g.,
SEC Regulation S-X) for discussion of pro forma disclosure requirements, including those
related to pro forma EPS.
B.2.1.8 Form 8-K
Item 9.01(b)(1) of Form 8-K requires SEC registrants to “file any pro forma
financial information that would be required pursuant to Article 11 of Regulation S-X
(17 CFR 210) or Rule 8-05 of Regulation S-X (17 CFR 210.8-05) for smaller reporting
companies unless it involves the acquisition of a fund subject to Rule 6-11 of
Regulation S-X (17 CFR 210.6-11).”
B.2.1.9 Multiple Classes of Common Stock
In prior discussions, the SEC staff indicated that pro forma presentation of EPS
for multiple classes of stock for periods before their legal creation or issuance is
only permitted in registration statements used to register the newly created classes or
in proxy materials in which investors are asked to vote on the creation or issuance of
new classes. In those instances, the pro forma disclosure should be limited to the
issuer’s most recently completed fiscal year and subsequent interim period. The staff
has objected when a registrant presents pro forma amounts after new classes of stock
have been created and issued. For the period that includes the issuance of a tracking
stock, a company should present historical EPS for (1) its single class of stock up to
the issuance date of the tracking stock and (2) each class of stock for the periods for
which the tracking stock was outstanding. The creation of the tracking stock capital
structure should not be treated similarly to a stock split and therefore should not be
accounted for retroactively.
B.2.2 Pro Forma EPS Required by U.S. GAAP
The Codification does not specifically require the disclosure of pro forma EPS. However, certain guidance in U.S. GAAP addresses the disclosure of pro forma financial information, which could include pro forma EPS. Section 3610 of the FRM indicates that pro forma disclosures presented under U.S. GAAP may differ in style and content from those required by Article 11.
Codification references to pro forma disclosures include the following:
- ASC 450-20-50-10 indicates that for asset impairments or losses arising after the date of the financial statements, “[d]isclosure may best be made by supplementing the historical financial statements with pro forma financial data giving effect to the loss as if it had occurred at the date of the financial statements.”
- ASC 805-10-50-2(h) requires a public entity to disclose certain supplemental pro forma information related to business combinations to reflect the combined entity as though the combination had occurred as of the beginning of the comparable prior annual reporting period. Disclosure of pro forma EPS is not specifically required. However, Item 9.01 of Form 8-K requires SRCs and non-SRCs to file pro forma financial information for significant acquisitions, including EPS, through the issuer’s most recently filed balance sheet. See Deloitte’s Roadmap SEC Reporting Considerations for Business Combinations for more information about the pro forma EPS requirements for business combinations.
- ASC 855-10-50-3 states, in part, that “[a]n entity also shall consider supplementing the historical financial statements with pro forma financial data [regarding a material subsequent event]. Occasionally, a nonrecognized subsequent event may be so significant that disclosure can best be made by means of pro forma financial data. Such data shall give effect to the event as if it had occurred on the balance sheet date.”
B.3 Calculating Pro Forma EPS
B.3.1 General
Article 11 and Section
3200 of the FRM include computational guidance related to pro
forma EPS. However, there is no such computational guidance in U.S. GAAP.
SEC Regulation S-X, Rule 11-02(b)(9)(i), contains the following description of
the pro forma EPS information that must be included in pro forma financial
statements:
Historical and pro forma basic and diluted per share amounts
based on continuing operations attributable to the controlling interests and
the number of shares used to calculate such per share amounts must be
presented on the face of the pro forma condensed statement of comprehensive
income and only give effect to Transaction Accounting Adjustments and
Autonomous Entity Adjustments.
In addition to describing the pro forma EPS information to be included in pro
forma financial statements, SEC Regulation S-X, Rule 11-02(b)(9)(ii), discusses
the calculation of pro forma EPS and states:
The number of
shares used in the calculation of the pro forma per share amounts must be
based on the weighted average number of shares outstanding during the period
adjusted to give effect to the number of shares issued or to be issued to
consummate the transaction, or if applicable whose proceeds will be used to
consummate the transaction as if the shares were outstanding as of the
beginning of the period presented. Calculate the pro forma effect of
potential common stock being issued in the transaction (e.g., a convertible
security), or the proceeds of which will be used to consummate the
transaction, on pro forma earnings per share in accordance with U.S. GAAP or
IFRS-IASB, as applicable, as if the potential common stock were outstanding
as of the beginning of the period presented.
Under Article 11, an entity will generally include in the denominator of pro forma EPS only those common shares whose proceeds are being reflected in pro forma adjustments in the income statements, such as proceeds used for debt repayment or business acquisitions. However, an entity may be required to reflect in its pro forma EPS calculation incremental shares arising from an offering whose proceeds are assumed to pay a distribution/dividend to shareholders, even if such a distribution is not reflected in the pro forma income statement. See further discussion in Section B.3.2.
Regardless of the reason for presenting or disclosing pro forma EPS in a filing with the SEC, the pro forma EPS amounts should be accompanied by transparent disclosure of how such amounts were calculated.
Connecting the Dots
The presentation of pro forma EPS should not alter in any way the calculations
of historical basic and diluted EPS under ASC 260. That is, calculations
of basic and diluted EPS under ASC 260 should not incorporate any of the
assumptions about the use of offering proceeds or other transactions
that have not yet occurred but that may trigger a requirement to present
or disclose pro forma EPS. Rather, transactions affecting EPS should be
reflected in EPS calculations under ASC 260 only after they have
occurred.
B.3.2 Distributions From the Proceeds of an Offering
The objective of calculating pro forma EPS is to include an additional number of
common shares in the denominator to reflect that the entity would have to raise
proceeds through the issuance of common stock to fund dividends that exceed
current-period earnings. That is, pro forma EPS should be calculated by
including an incremental number of common shares (not to exceed the total number
of common shares being offered) that, on the basis of the offering price, would
be needed to pay the portion of the dividend that exceeds earnings. See
Example B-1 for
an illustration.
B.3.3 Change in Capitalization at or Before Closing of an IPO
When outstanding securities, such as convertible securities or restricted share-based units, will be converted into common stock in conjunction with an IPO, and that conversion will occur after the latest balance sheet presented and result in a material reduction of EPS (excluding the effects of the offering), pro forma EPS amounts should reflect the conversion of the securities into common stock. The pro forma EPS amounts should not, however, reflect any additional shares of common stock being offered in the IPO.
The nature of the pro forma adjustments to the historical EPS amounts will depend on the specific facts and circumstances. Such adjustments may include adjustments to the numerator in addition to the inclusion of additional common shares in the denominator. If the security to be converted is a participating security, an entity would be required to adjust the numerator to remove the effects of such participation from the historical EPS amounts. Moreover, for convertible securities, the numerator for basic EPS would need to be adjusted to remove any interest or dividends that reduced income available to common stockholders. A similar type of adjustment may also be required in the calculation of pro forma diluted EPS. However, in some cases, diluted EPS and pro forma diluted EPS will be the same. See Example B-2 for an illustration.
B.3.4 Use of Proceeds From Offering of Convertible Securities to Extinguish Preferred Stock or Debt
The pro forma adjustments required under SAB Topic 3.A will depend on the circumstances associated with the existing security being extinguished, the offered security, and other equity or participating securities in the entity’s capital structure. In certain situations, the pro forma adjustments will involve the initial application, alteration, or cessation of the two-class method of calculating EPS. This may be the case when (1) the extinguished security was a participating security, (2) the offered security is a participating security, or (3) the entity has other participating securities or multiple classes of common stock. Regardless of the facts and circumstances related to the extinguished security, the offered security, or the other equity or participating securities in the entity’s capital structure, the following are always true in the calculation of pro forma EPS:
- The pro forma adjustments to the denominator as a result of the offered security should be limited to the portion of the offering proceeds that will be used to extinguish the existing security. This amount will be determined by considering both the redemption price of the existing security and the proceeds that must be raised in the offering to repay that redemption price. The quantity of securities needed to pay the redemption price of the existing security should be based on the offering price in the registration statement. Additional proceeds raised in the offering that will be used for general corporate purposes do not affect the calculations of pro forma EPS.
- The pro forma adjustments should be calculated in a manner that reflects only the time during which the existing security or offered security was (or would be) outstanding during the financial reporting period. For example, if an entity is retiring nonconvertible debt that was issued at the beginning of the second quarter of a fiscal year with the proceeds from an offering of convertible securities at or after the end of the fiscal year, the adjustments to the numerator would only reflect interest expense on the existing debt for three quarters. Similarly, the adjustments to the numerator and the incremental potential common shares added to the denominator of the calculation of pro forma diluted EPS under the if-converted method would also be weighted for three quarters during the annual period.
The table below discusses various other matters not specifically addressed in
the SEC’s computational guidance that may be relevant to the calculation of pro
forma EPS under SAB Topic 3.A.1
Table B-1
Additional Matter
|
Additional Considerations
|
---|---|
The existing security that is being
extinguished was accounted for at fair value through
earnings.
|
The mark-to-market adjustments should be
reversed since they would not have been recorded if the
existing security was extinguished.
|
The existing security that is being
extinguished contained an embedded derivative that was
separately recognized under ASC 815.
|
The mark-to-market adjustments on the
embedded derivative should be reversed since they would
not have been recorded if the existing security was
extinguished.
|
The existing security that is being
extinguished was preferred stock that was classified in
temporary equity and remeasured to its redemption
amount.
|
The adjustments previously recognized
for changes in the redemption amount should be reversed
since they would not have been recorded if the existing
security was extinguished (i.e., the amounts that
reduced income available to common stockholders would be
added back to the numerator).
|
The existing security allowed for
conversion to be settled in cash or common stock.
|
The adjustments to historical EPS should
be based on an assumption that the security would be
share-settled.
|
The offered security will be accounted
for at fair value through earnings.
|
If potential mark-to-market adjustments
on the offered security that will be recognized after
the issuance of the security are not included in the
calculation of pro forma EPS amounts for the period
after the issuance of the offered security, the
disclosure should indicate that these adjustments are
not included in the calculation of pro forma EPS because
such amounts are not reasonably determinable.
|
The offered security will contain an
embedded derivative that must be separated under ASC
815.
|
Management should estimate the initial
fair value of the embedded derivative to calculate the
interest expense or dividends on the host contract for
the offered security under the interest method. If
potential mark-to-market adjustments on the embedded
derivative that will be recognized after the issuance of
the security are not included in the calculation of pro
forma EPS amounts for the period after the issuance of
the offered security, the disclosure should indicate
that these adjustments are not included in the
calculation of pro forma EPS because such amounts are
not reasonably determinable.
|
The interest or dividends on the offered
security are variable.
|
The entity should use judgment on the
basis of the specific terms and other GAAP. If the
variability is based solely on a market index, the
relevant spot index should be used.
|
The interest or dividends on the offered
security are at an increasing rate or contain other
unique terms.
|
The entity should consider the interest
or dividend terms in the offering document in
determining the application of the interest method.
|
The offered security is puttable or
callable.
|
Such calls or puts should not be
considered to result in a life of the offered security
that is shorter than the period during which the
existing security was outstanding. Entities should use
judgment and consider the requirements of other GAAP in
evaluating whether the puts or calls affect the interest
or dividend yield on the offered security.
|
The offered security will need to be
classified in temporary equity and remeasured to its
redemption amount.
|
In assessing the impact of potential
redemption amount adjustments on the calculation of pro
forma EPS, an entity will need to use judgment and
consider the facts and circumstances as well as its
selected accounting policies under ASC 480-10-S99-3A.
For example:
If the redemption price is variable, the
entity should consider the nature of the variability to
determine the redemption amount adjustments or should
disclose that such an estimate is not reasonably
determinable.
|
The offered security is a convertible
security for which a conversion may be settled in cash
or stock.
|
Entities are required to assume share
settlement when calculating pro forma EPS.
|
The entity historically applied the
two-class method as a result of the existence of other
participating securities or multiple classes of common
stock (i.e., in the absence of the existing security or
offered security, the two-class method of EPS is
required).
|
The adjustments to historical basic and
diluted EPS arising from the extinguishment of the
existing security and the offered security may affect
the historical application of the two-class method
(e.g., the allocation of undistributed earnings); thus,
an entity will be required to take additional
considerations into account in calculating pro forma
EPS.
|
B.3.5 Changes in Tax Status in Conjunction With an IPO
The financial statements presented in a registration statement on Form S-1 for
the periods in which an entity was a nontaxable entity should not be restated
for the effects of income taxes. Rather, as discussed in paragraph 3410.1 of the
FRM, the entity should provide pro forma disclosures to illustrate the effect of
income taxes on those years in accordance with Article 11. Section 3270 of the FRM
states that the tax rate used for the pro forma calculations should normally
equal the “statutory rate in effect during the periods for which the pro forma
income statements are presented.”
For more information about the implications of a change in tax status, see
Deloitte’s Roadmap Income
Taxes. Note that there are several ways in which an
entity’s tax and legal structure may change as a result of the IPO process, all
of which may have unique impacts on income tax measurement, presentation, and
disclosures. Management should consult with tax advisers in determining the
income tax implications of such changes well in advance of the IPO.
Footnotes
1
The matters discussed below may also be relevant to
certain changes in capitalization in conjunction with an IPO.
B.4 Examples
B.4.1 Distributions From the Proceeds of an Offering
Example B-1
Assume the following:
- Company A, a calendar-year-end entity, plans to complete an IPO in June 20X9.
- Before its IPO, A had 5,000 shares of common stock outstanding.
- In the IPO, A expects to issue 1 million shares of common stock at an expected offering price of $100 per share.
- For the year ended December 31, 20X8, A has net income of $100,000.
- On December 31, 20X8, A declares a dividend of $1,000 per share to its owners (i.e., a total dividend of $5 million). No other dividends are paid or declared in 20X8.
Because the dividends for 20X8 exceed A’s net income for this year, the SEC
staff would consider the dividend payments to have been
made in contemplation of A’s planned IPO. Accordingly,
in the Form S-1 filing for its IPO, A should present pro
forma EPS outside the financial statements for the year
ended December 31, 20X8, and for the three months ended
March 31, 20X9, that reflects an additional 49,000
common shares in the denominator of both basic and
diluted EPS.
The incremental number of shares of common stock included in the denominator is calculated as follows:
Since the 49,000 incremental common shares required for the pro forma EPS disclosure do not exceed the common shares being offered in the IPO, all of the incremental shares should be included in the calculation of pro forma EPS.
B.4.2 Change in Capitalization at or Before Closing of an IPO
Example B-2
Assume the following:
- Company B, a calendar-year-end entity, plans to complete an IPO in March 20X5. The latest financial statements included in the Form S-1 registration statement are as of and for the year ended December 31, 20X4.
- Company B has the following outstanding securities:
- 100,000 shares of common stock.
- 100,000 shares of participating convertible preferred stock that are automatically converted into common shares upon the occurrence of an IPO (the “preferred shares”). The aggregate liquidation preference of the preferred shares is $1 million. Each preferred share is convertible into one share of common stock. The preferred shares receive dividends, on a cumulative basis, at an annual rate of 8 percent (or $80,000 per annum). In addition, after such payments, the holders are entitled to participate in dividends with common shareholders on a 35:65 basis and such participation is determined on the basis of the number of shares of common stock issuable on conversion of the preferred shares.
- Options that allow the holders to purchase 50,000 shares of common stock that are not automatically exercised upon the occurrence of an IPO. The options do not represent participating securities.
- For the year ended December 31, 20X4:
- Company B reports net income of $500,000.
- No dividends are paid or declared on common stock.
- Under the treasury stock method, the options result in 25,000 incremental shares.
Company B’s calculation of EPS for the year ended December 31, 20X4, is as follows:
Basic EPS:
Diluted EPS:
Diluted EPS is presented under the if-converted method since it is more dilutive than the two-class method of calculating diluted EPS.
(a) Two-class method:
(b) If-converted method:
Company B calculates pro forma EPS for the year ended December 31, 20X4, which
would be presented outside the financial statements, as
follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Note that diluted pro forma EPS is not calculated under the two-class method because, after the conversion of the preferred shares, there are no remaining participating securities.
B.4.3 Use of Proceeds From Offering of Convertible Securities to Extinguish Preferred Stock or Debt
Example B-3
Assume the following:
- Company C is offering $500 million of convertible preferred stock (the “preferred stock”).
- The “use of proceeds” section in the registration statement for the offering states that the proceeds from issuance of the preferred stock will be used to redeem C’s outstanding senior secured notes (the “notes”) and for general corporate purposes.
- Key terms and characteristics of the notes include:
- The notes are not convertible into common stock.
- The notes are not participating securities.
- The notes are accounted for at amortized cost.
- The current amortized cost of the notes is $245 million.
- The outstanding principal amount of the notes is $250 million.
- The notes do not contain any embedded derivatives that must be accounted for separately.
- The notes contain an embedded call option that allows C to redeem them at any time for the principal amount plus a make-whole premium. The current redemption amount is $260 million. Therefore, the redemption will result in a pretax extinguishment loss of $15 million or $12 million, net of tax.
- The notes are outstanding during the entire year ended December 31, 20X1.
- Interest expense on the notes during the year ended December 31, 20X1, net of tax, is $9 million.
- Key terms and characteristics of the preferred stock include:
- The conversion option in the preferred stock must be settled in common stock.
- Upon full conversion, C would be required to issue 8 million shares of common stock.
- The conversion option in the preferred stock is not “in-the-money” as of the issuance date.
- The preferred stock is not a participating security.
- Dividends on the preferred stock, which are cumulative and not tax-deductible, accrue at a rate of 3.5 percent per annum.
- The preferred stock will be classified in permanent equity.
- The preferred stock will not contain any embedded derivatives that must be accounted for separately.
- Before the offering, C’s capital structure consists solely of the notes, common stock, and options to purchase common stock, which are not participating securities. For the year ended December 31, 20X1, on a weighted-average basis, C has 10 million shares of common stock outstanding and 1 million incremental potential common shares, as calculated under the treasury stock method.
- Company C reports net income of $50 million for the year ended December 31, 20X1.
Company C presents basic and diluted EPS for the year ended December 31, 20X1, as follows:
Basic EPS:
Diluted EPS:
The adjustments to C’s historical basic and diluted EPS to arrive at pro forma basic and diluted EPS for the year ended December 31, 20X1, are as follows:
EPS | Nature of Pro Forma Adjustments |
---|---|
Basic | Numerator:
The numerator in the historical calculation of
basic EPS should be decreased by $12.1 million,
calculated as the $12 million loss on
extinguishment of the notes, net of tax, plus the
$100,000 difference between interest on the notes
and dividends on the preferred stock, which is
calculated as follows: Denominator: There are no adjustments to the denominator in the historical calculation of basic EPS. |
Diluted | Numerator: The numerator in the historical calculation of diluted EPS should be decreased
by $3 million, representing the $12 million loss
on the extinguishment of debt, net of tax, less
the add-back of $9 million of interest on the
notes, net of tax. The dividends on the preferred
stock do not affect the numerator for pro forma
diluted EPS because the preferred stock is
dilutive under the if-converted method. Denominator: The denominator in the historical calculation of diluted EPS should be increased
by 4.16 million shares of common stock,
representing the number of shares of common stock
to be issued from the application of the
if-converted method to $260 million of preferred
stock (i.e., 8 million common shares issuable upon
full conversion × [$260 million ÷ $500 million]).
No additional adjustments are necessary since the
notes are not convertible into common stock. |
The calculation of pro forma basic and diluted EPS for
the year ended December 31, 20X1, which would be
presented outside the financial statements, is as
follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Example B-4
Assume the following:
- Company D is offering 100 million common shares (the “common stock”) and detachable warrants to purchase 100 million common shares (the “warrants”). On the basis of the offering prices, D expects to raise $900 million.
- The “use of proceeds” section in the registration statement for the offering states that the proceeds from issuance of common stock and warrants will be used to redeem all of D’s outstanding senior secured debentures (the “debentures”) and an amount of outstanding convertible preferred stock (the “preferred stock”) that is tendered by the holders in accordance with the terms of a tender offer but not to exceed $500 million. Company D expects that the tender offer will result in the repurchase of half of the outstanding preferred stock for $500 million. The anticipated purchase price is equal to the carrying amount of the preferred stock to be redeemed.
- Key terms and characteristics of the debentures include:
- The debentures are not convertible into common stock.
- The debentures are not participating securities.
- The debentures are accounted for at amortized cost.
- The current amortized cost of the debentures is $400 million.
- The outstanding principal amount of the debentures is $400 million.
- The debentures do not contain any embedded derivatives that must be accounted for separately.
- The debentures contain an embedded call option that allows D to redeem them at any time after December 31, 20X2, at the outstanding principal amount.
- The debentures were outstanding during the entire year ended December 31, 20X2.
- Interest expense on the debentures during the year ended December 31, 20X2, net of tax, was $18 million.
- Key terms and characteristics of the preferred stock include:
- The conversion option in the preferred stock must be settled in common stock.
- Upon full conversion, D would be required to issue 50 million shares of common stock.
- The preferred stock is not in-the-money on the issuance date.
- The preferred stock is not a participating security.
- Dividends on the preferred stock, which are cumulative and not tax-deductible, accrue at a rate of 6 percent per annum.
- The preferred stock is classified in permanent equity.
- The preferred stock does not contain any embedded derivatives that must be accounted for separately.
- The aggregate liquidation preference of the preferred stock is $1 billion.
- The preferred stock is outstanding during the entire year ended December 31, 20X2.
- Key terms and characteristics of the warrants include:
- The warrants are not participating securities.
- The exercise price of the warrants will be set at a 35 percent premium to the market price of D’s common stock.
- At no point during the year ended December 31, 20X2, did the fair value of D’s common stock exceed the exercise price of the warrants.
- Before the offering, D’s capital structure consists solely of the debentures, preferred stock, common stock, and options to purchase common stock, which are not participating securities. For the year ended December 31, 20X2, on a weighted-average basis, D has 300 million shares of common stock outstanding and 10 million incremental potential common shares related to the options to purchase common stock, as calculated under the treasury stock method.
- Company D reports net income of $500 million for the year ended December 31, 20X2.
Company D presents basic and diluted EPS for the year ended December 31, 20X2, as follows:
Basic EPS:
Diluted EPS:
The adjustments that D makes to its historical basic and diluted EPS to arrive at pro forma basic and diluted EPS for the year ended December 31, 20X2, are as follows:
EPS | Nature of Pro Forma Adjustments |
---|---|
Basic | Numerator: The numerator in the historical calculation of basic EPS should be increased by
$48 million, calculated as follows: Denominator: The denominator in the historical calculation of basic EPS should be increased by 100 million for the common shares to be issued in the offering. Note that the issuance of the warrants does not affect the calculation of pro forma basic EPS since the warrants do not represent participating securities. |
Diluted | Numerator: The numerator in the historical calculation of diluted EPS should be increased by $18 million, representing the add-back of interest, net of tax, on the notes. No adjustment is needed for dividends on the preferred stock because the numerator in the historical calculation of diluted EPS included an add-back for such dividends under the if-converted method. Denominator: The denominator in the historical calculation of diluted EPS should be increased by
75 million shares of common stock, calculated as follows: There is no incremental dilutive impact of the warrants to be issued in the offering because they are out-of-the-money. |
The calculation of pro forma basic and diluted EPS for
the year ended December 31, 20X2, which would be
presented outside the financial statements, is as
follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Example B-5
Assume the following:
- Company E is offering $500 million of convertible notes (the “notes”).
- The “use of proceeds” section in the registration statement for the offering states that the proceeds from issuance of the notes will be used to retire E’s outstanding preferred stock (the “preferred stock”).
- Key terms and characteristics of the preferred stock include:
- There are 500,000 shares of preferred stock outstanding.
- Each share of preferred stock has a liquidation preference of $1,000 per share.
- The preferred stock is not convertible.
- Dividends on the preferred stock, which are cumulative and not tax-deductible, accrue at a rate of 6 percent per annum. The preferred stock also participates in dividends declared on E’s common stock on a 1:1 basis, calculated on the basis of the number of shares outstanding.
- The preferred stock is classified in permanent equity.
- The preferred stock does not contain any embedded derivatives that must be accounted for separately.
- Company E has a call option that allows it to redeem the preferred stock for $500 million.
- The preferred stock is recorded at $500 million on E’s balance sheet.
- The preferred stock is outstanding during the entire year ended December 31, 20X2.
- Key terms and characteristics of the notes include:
- The notes are convertible into common stock at a conversion rate of 50 shares for each 1,000 principal amount (or 25 million shares of common stock upon full conversion).
- The notes bear interest at an annual rate of 3.375 percent. Interest on the notes is tax-deductible (assume a 20 percent tax rate).
- The notes also participate in dividends paid on common stock on an as-converted basis.
- The notes will be accounted for at amortized cost.
- The notes will not contain any embedded derivative that must be accounted for separately.
- Before the offering, E’s capital structure consists solely of the preferred stock, common stock, and options to purchase common stock, which are not participating securities. For the year ended December 31, 20X2, on a weighted-average basis, E has 150 million shares of common stock outstanding and 5 million incremental potential common shares related to the options to purchase common stock, as calculated under the treasury stock method.
- Company E reports net income of $250 million for the year ended December 31, 20X2.
- Company E does not declare any dividends on common stock during the year ended December 31, 20X2.
- Company E is subject to the two-class method because the preferred stock is a participating security.
Company E presents basic and diluted EPS for the year ended December 31, 20X2, as follows:
Basic EPS:
Diluted EPS:
The adjustments that E makes to its historical basic and diluted EPS to arrive at pro forma basic and diluted EPS for the year ended December 31, 20X2, are as follows:
EPS | Nature of Pro Forma Adjustments |
---|---|
Basic | Numerator: The numerator in the historical calculation of basic EPS should be decreased by $16,554,817, calculated as follows: The extinguishment of the preferred stock will
not result in an adjustment to retained earnings
because the redemption amount and the carrying
amount of the preferred stock are the same;
therefore, no adjustment is necessary for the
extinguishment on the basis of the facts in this
example. Denominator: There are no adjustments to the denominator in the historical calculation of basic EPS. |
Diluted | Numerator: The numerator in the historical calculation of diluted EPS should be decreased by $15,639,827, calculated as follows: Denominator: There are no adjustments to the denominator in the historical calculation of diluted EPS because EPS is more dilutive under the two-class method than under the if-converted method. |
The calculation of pro forma basic and diluted EPS for the year ended December
31, 20X2, which would be presented outside the financial
statements, is as follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Pro forma diluted EPS is presented under the two-class method since it is more dilutive than the if-converted method.
(a) Two-class method:
(b) If-converted method:
Appendix C — Glossary of Selected Terms
Appendix C — Glossary of Selected Terms
This appendix contains glossary terms from ASC 260 and selected glossary terms from the ASC master glossary.
ASC 260-10 Glossary and ASC Master Glossary
Accounting Change
A change in an accounting principle, an accounting estimate, or the reporting entity. The correction of an error in previously issued financial statements is not an accounting change.
Allocated Shares
Allocated shares are shares in an employee stock ownership plan trust that have been assigned to individual participant accounts based on a known formula. Internal Revenue Service (IRS) rules require allocations to be nondiscriminatory generally based on compensation, length of service, or a combination of both. For any particular participant such shares may be vested, unvested, or partially vested.
Antidilution
An increase in earnings per share amounts or a decrease in loss per share amounts.
Award
The collective noun for multiple instruments with the same terms and conditions
granted at the same time either to a single grantee or to a
group of grantees. An award may specify multiple vesting
dates, referred to as graded vesting, and different parts of
an award may have different expected terms. References to an
award also apply to a portion of an award.
Basic Earnings per Share
The amount of earnings for the period available to each share of common stock outstanding during the reporting period.
Call Option
A contract that allows the holder to buy a specified quantity of stock from the writer of the contract at a fixed price for a given period. See Option and Purchased Call Option.
Change in Accounting Estimate
A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, and warranty obligations.
Change in Accounting Principle
A change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle.
Change in the Reporting Entity
A change that results in financial statements that, in effect, are those of a different reporting entity. A change in the reporting entity is limited mainly to the following:
- Presenting consolidated or combined financial statements in place of financial statements of individual entities
- Changing specific subsidiaries that make up the group of entities for which consolidated financial statements are presented
- Changing the entities included in combined financial statements.
Neither a business combination accounted for by the acquisition method nor the consolidation of a variable interest entity (VIE) pursuant to Topic 810 is a change in reporting entity.
Committed-to-Be-Released Shares
Committed-to-be-released shares are shares that, although not legally released, will be released by a future scheduled and committed debt service payment and will be allocated to employees for service rendered in the current accounting period. The period of employee service to which shares relate is generally defined in the employee stock ownership plan documents. Shares are legally released from suspense and from serving as collateral for employee stock ownership plan debt as a result of payment of debt service. Those shares are required to be allocated to participant accounts as of the end of the employee stock ownership plan’s fiscal year. Formulas used to determine the number of shares released can be based on either of the following:
- The ratio of the current principal amount to the total original principal amount (in which case unearned employee stock ownership plan shares and debt balance will move in tandem)
- The ratio of the current principal plus interest amount to the total original principal plus interest to be paid.
Shares are released more rapidly under the second method than under the first. Tax law permits the first method only if the employee stock ownership plan debt meets certain criteria.
Common Stock
A stock that is subordinate to all other stock of the issuer. Also called common shares.
Comprehensive Income
The change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income comprises both of the following:
- All components of net income.
- All components of other comprehensive income.
Consolidated Financial Statements
The financial statements of a consolidated group of entities that include a parent and all its subsidiaries presented as those of a single economic entity.
Consolidated Group
A parent and all its subsidiaries.
Contingent Issuance
A possible issuance of shares of common stock that is dependent on the satisfaction of certain conditions.
Contingent Stock Agreement
An agreement to issue common stock (usually in connection with a business combination) that is dependent on the satisfaction of certain conditions. See Contingently Issuable Shares.
Contingently Convertible Instruments
Contingently convertible instruments are instruments that have embedded conversion features that are contingently convertible or exercisable based on either of the following:
- A market price trigger
- Multiple contingencies if one of the contingencies is a market price trigger and the instrument can be converted or share settled based on meeting the specified market condition.
A market price trigger is a market condition that is based at least in part on the issuer’s own share price. Examples of contingently convertible instruments include contingently convertible debt, contingently convertible preferred stock, and the instrument described by paragraph 260-10-45-43, all with embedded market price triggers.
Contingently Issuable Shares
Shares issuable for little or no cash consideration upon the satisfaction of certain conditions pursuant to a contingent stock agreement. Also called contingently issuable stock. See Contingent Stock Agreement.
Conversion Rate
The ratio of the number of common shares issuable upon conversion to a unit of a convertible security. For example, $100 face value of debt convertible into 5 shares of common stock would have a conversion ratio of 5:1. Also called conversion ratio.
Convertible Security
A security that is convertible into another security based on a conversion rate. For example, convertible preferred stock that is convertible into common stock on a two-for-one basis (two shares of common for each share of preferred).
Diluted Earnings per Share
The amount of earnings for the period available to each share of common stock outstanding during the reporting period and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period.
Dilution
A reduction in EPS resulting from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued upon the satisfaction of certain conditions.
Direct Loan
A direct loan is a loan made by a lender other than the employer to the employee stock ownership plan. Such loans often include some formal guarantee or commitment by the employer.
Down Round Feature
A feature in a financial instrument that reduces the strike price of an issued financial instrument if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below the currently stated strike price of the issued financial instrument.
A down round feature may reduce the strike price of a financial instrument to the current issuance price, or the reduction may be limited by a floor or on the basis of a formula that results in a price that is at a discount to the original exercise price but above the new issuance price of the shares, or may reduce the strike price to below the current issuance price. A standard antidilution provision is not considered a down round feature.
Dropdown
A transfer of certain net assets from a sponsor or general partner to a master limited partnership in exchange for consideration.
Earnings per Share
The amount of earnings attributable to each share of common stock. For convenience, the term is used to refer to either earnings or loss per share.
Employee
An individual over whom the grantor of a share-based compensation award exercises or has the right to exercise sufficient control to establish an employer-employee relationship based on common law as illustrated in case law and currently under U.S. Internal Revenue Service (IRS) Revenue Ruling 87-41. A reporting entity based in a foreign jurisdiction would determine whether an employee-employer relationship exists based on the pertinent laws of that jurisdiction. Accordingly, a grantee meets the definition of an employee if the grantor consistently represents that individual to be an employee under common law. The definition of an employee for payroll tax purposes under the U.S. Internal Revenue Code includes common law employees. Accordingly, a grantor that classifies a grantee potentially subject to U.S. payroll taxes as an employee also must represent that individual as an employee for payroll tax purposes (unless the grantee is a leased employee as described below). A grantee does not meet the definition of an employee solely because the grantor represents that individual as an employee for some, but not all, purposes. For example, a requirement or decision to classify a grantee as an employee for U.S. payroll tax purposes does not, by itself, indicate that the grantee is an employee because the grantee also must be an employee of the grantor under common law.
A leased individual is deemed to be an employee of the lessee if all of the following requirements are met:
- The leased individual qualifies as a common law employee of the lessee, and the lessor is contractually required to remit payroll taxes on the compensation paid to the leased individual for the services provided to the lessee.
- The lessor and lessee agree in writing to all of the following conditions related to the leased individual:
- The lessee has the exclusive right to grant stock compensation to the individual for the employee service to the lessee.
- The lessee has a right to hire, fire, and control the activities of the individual. (The lessor also may have that right.)
- The lessee has the exclusive right to determine the economic value of the services performed by the individual (including wages and the number of units and value of stock compensation granted).
- The individual has the ability to participate in the lessee’s employee benefit plans, if any, on the same basis as other comparable employees of the lessee.
- The lessee agrees to and remits to the lessor funds sufficient to cover the complete compensation, including all payroll taxes, of the individual on or before a contractually agreed upon date or dates.
A nonemployee director does not satisfy this definition of employee. Nevertheless, nonemployee directors acting in their role as members of a board of directors are treated as employees if those directors were elected by the employer’s shareholders or appointed to a board position that will be filled by shareholder election when the existing term expires. However, that requirement applies only to awards granted to nonemployee directors for their services as directors. Awards granted to those individuals for other services shall be accounted for as awards to nonemployees.
Employee Stock Ownership Plan
An employee stock ownership plan is an employee benefit plan that is described by the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code of 1986 as a stock bonus plan, or combination stock bonus and money purchase pension plan, designed to invest primarily in employer stock. Also called an employee share ownership plan.
Employer Loan
An employer loan is a loan made by the employer to the employee stock ownership plan, with no related outside loan.
Equity Interests
Used broadly to mean ownership interests of investor-owned entities; owner, member, or participant interests of mutual entities; and owner or member interests in the net assets of not-for-profit entities.
Equity Restructuring
A nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying an option or similar award to change, such as a stock dividend, stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend.
Exercise Price
The amount that must be paid for a share of common stock upon exercise of an option or warrant.
Fair Value
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Financial Instrument
Cash, evidence of an ownership interest in an entity, or a contract that both:
- Imposes on one entity a contractual obligation either:
- To deliver cash or another financial instrument to a second entity
- To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right either:
- To receive cash or another financial instrument from the first entity
- To exchange other financial instruments on potentially favorable terms with the first entity.
The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.
Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. All contractual rights (contractual obligations) that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets (liabilities) in financial statements — that is, they may be off-balance-sheet — because they fail to meet some other criterion for recognition.
For some financial instruments, the right is held by or the obligation is due from (or the obligation is owed to or by) a group of entities rather than a single entity.
Financial Statements Are Available to Be Issued
Financial statements are considered available to be issued when they are complete in a form and format that complies with GAAP and all approvals necessary for issuance have been obtained, for example, from management, the board of directors, and/or significant shareholders. The process involved in creating and distributing the financial statements will vary depending on an entity’s management and corporate governance structure as well as statutory and regulatory requirements.
Financial Statements Are Issued
Financial statements are considered issued when they are widely distributed to shareholders and other financial statement users for general use and reliance in a form and format that complies with GAAP. (U.S. Securities and Exchange Commission [SEC] registrants also are required to consider the guidance in paragraph 855-10-S99-2.)
If-Converted Method
A method of computing EPS data that assumes conversion of convertible securities at the beginning of the reporting period (or at time of issuance, if later).
Income Available to Common Stockholders
Income (or loss) from continuing operations or net income (or net loss) adjusted for preferred stock dividends.
Income From Continuing Operations
Income after applicable income taxes but excluding the results of discontinued operations, the cumulative effect of accounting changes, translation adjustments, purchasing power gains and losses on monetary items, and increases and decreases in the current cost or lower recoverable amount of nonmonetary assets and liabilities.
Indirect Effects of a Change in Accounting Principle
Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively. An example of an indirect effect is a change in a nondiscretionary profit sharing or royalty payment that is based on a reported amount such as revenue or net income.
Indirect Loan
An indirect loan is a loan made by the employer to the employee stock ownership plan, with a related outside loan to the employer.
Issuer’s Equity Shares
The equity shares of any entity whose financial statements are included in the consolidated financial statements.
Mandatorily Redeemable Financial Instrument
Any of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.
Market Condition
A condition affecting the exercise price, exercisability, or other pertinent factors used in determining the fair value of an award under a share-based payment arrangement that relates to the achievement of either of the following:
- A specified price of the issuer’s shares or a specified amount of intrinsic value indexed solely to the issuer’s shares
- A specified price of the issuer’s shares in terms of a similar (or index of similar) equity security (securities). The term similar as used in this definition refers to an equity security of another entity that has the same type of residual rights. For example, common stock of one entity generally would be similar to the common stock of another entity for this purpose.
Net Income
A measure of financial performance resulting from the aggregation of revenues, expenses, gains, and losses that are not items of other comprehensive income. A variety of other terms such as net earnings or earnings may be used to describe net income.
Noncontrolling Interest
The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.
Nonvested Shares
Shares that an entity has not yet issued because the agreed-upon consideration, such as the delivery of specified goods or services and any other conditions necessary to earn the right to benefit from the instruments, has not yet been satisfied. Nonvested shares cannot be sold. The restriction on sale of nonvested shares is due to the forfeitability of the shares if specified events occur (or do not occur).
Option
Unless otherwise stated, a call option that gives the holder the right to purchase shares of common stock from the reporting entity in accordance with an agreement upon payment of a specified amount. Options include, but are not limited to, options granted and stock purchase agreements entered into with grantees. Options are considered securities. See Call Option.
Other Comprehensive Income
Revenues, expenses, gains, and losses that under generally accepted accounting principles (GAAP) are included in comprehensive income but excluded from net income.
Parent
An entity that has a controlling financial interest in one or more subsidiaries. (Also, an entity that is the primary beneficiary of a variable interest entity.)
Participating Security
A security that may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not. The form of such participation does not have to be a dividend — that is, any form of participation in undistributed earnings would constitute participation by that security, regardless of whether the payment to the security holder was referred to as a dividend.
Physical Settlement
A form of settling a financial instrument under which both of the following conditions are met:
- The party designated in the contract as the buyer delivers the full stated amount of cash or other financial instruments to the seller.
- The seller delivers the full stated number of shares of stock or other financial instruments or nonfinancial instruments to the buyer.
Potential Common Stock
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.
Preferred Stock
A security that has preferential rights compared to common stock.
Public Business Entity
A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.
- It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
- It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
- It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
- It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.
Public Entity
Definition 1
A business entity or a not-for-profit entity
that meets any of the following conditions:
-
It has issued debt or equity securities or is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
-
It is required to file financial statements with the Securities and Exchange Commission (SEC).
-
It provides financial statements for the purpose of issuing any class of securities in a public market.
Definition
2
An entity that meets any of the following
criteria:
-
Its debt or equity securities are traded in a public market, including those traded on a stock exchange or in the over-the-counter market (including securities quoted only locally or regionally).
-
It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
-
Its financial statements are filed with a regulatory agency in preparation for the sale of any class of securities.
Definition
3
An entity that meets any of the following
criteria:
-
Has equity securities that trade in a public market, either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
-
Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
-
Is controlled by an entity covered by the preceding criteria. That is, a subsidiary of a public entity is itself a public entity.
An entity that has only debt securities
trading in a public market (or that has made a filing with a
regulatory agency in preparation to trade only debt
securities) is not a public entity.
Publicly Traded Company
Definition 1
A publicly traded company includes any company whose securities trade in a public market on either of the following:
- A stock exchange (domestic or foreign)
- In the over-the-counter market (including securities quoted only locally or regionally), or any company that is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
Additionally, when a company is required to file or furnish financial statements with the SEC or makes a filing with a regulatory agency in preparation for sale of its securities in a public market it is considered a publicly traded company for this purpose.
Conduit debt securities refers to certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a state or local governmental entity for the express purpose of providing financing for a specific third party (the conduit bond obligor) that is not a part of the state or local government’s financial reporting entity. Although conduit debt securities bear the name of the governmental entity that issues them, the governmental entity often has no obligation for such debt beyond the resources provided by a lease or loan agreement with the third party on whose behalf the securities are issued. Further, the conduit bond obligor is responsible for any future financial reporting requirements.
Definition
2
A business entity that has any of the
following characteristics:
-
Whose securities are traded in a public market on a domestic stock exchange or in the domestic over-the-counter market (including securities quoted only locally or regionally)
-
That is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets)
-
Whose financial statements are filed with a regulatory agency in preparation for the sale of any class of securities in a domestic market.
Publicly Traded Entity (or Public Entity)
Any entity that does not meet the definition of a nonpublic entity.
Purchased Call Option
A contract that allows the reporting entity to buy a specified quantity of its own stock from the writer of the contract at a fixed price for a given period. See Call Option.
Put Option
A contract that allows the holder to sell a specified quantity of stock to the writer of the contract at a fixed price during a given period.
Rabbi Trusts
Rabbi trusts are grantor trusts generally set up to fund compensation for a select group of management or highly paid executives. To qualify as a rabbi trust for income tax purposes, the terms of the trust agreement must explicitly state that the assets of the trust are available to satisfy the claims of general creditors in the event of bankruptcy of the employer.
Restatement
The process of revising previously issued financial statements to reflect the correction of an error in those financial statements.
Retrospective Application
The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years.
Reverse Treasury Stock Method
A method of recognizing the dilutive effect on EPS of satisfying a put obligation. It assumes that the proceeds used to buy back common stock (pursuant to the terms of a put option) will be raised from issuing shares at the average market price during the period. See Put Option.
Revised Financial Statements
Financial statements revised only for either of the following conditions:
- Correction of an error
- Retrospective application of U.S. GAAP.
Rights Issue
An offer to existing shareholders to purchase additional shares of common stock in accordance with an agreement for a specified amount (which is generally substantially less than the fair value of the shares) for a given period.
Securities and Exchange Commission Filer
An entity that is required to file or furnish its financial statements with either of the following:
- The Securities and Exchange Commission (SEC)
- With respect to an entity subject to Section 12(i) of the Securities Exchange Act of 1934, as amended, the appropriate agency under that Section.
Financial statements for other entities that are not otherwise SEC filers whose financial statements are included in a submission by another SEC filer are not included within this definition.
Securities and Exchange Commission Registrant
An entity (or an entity that is controlled by an entity) that meets any of the following criteria:
- It has issued or will issue debt or equity securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
- It is required to file financial statements with the Securities and Exchange Commission (SEC).
- It provides financial statements for the purpose of issuing any class of securities in a public market.
Security
Definition 1
The evidence of debt or ownership or a related right. It includes options and warrants as well as debt and stock.
Definition 2
A share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer that has all of the following characteristics:
- It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
- It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
- It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.
Share-Based Payment Arrangements
An arrangement under which either of the following conditions is met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments. b. The entity incurs liabilities to suppliers that meet either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. Equity shares refers only to shares that are accounted for as equity.
Also called share-based compensation arrangements.
Share-Based Payment Transactions
A transaction under a share-based payment arrangement, including a transaction in which an entity acquires goods or services because related parties or other holders of economic interests in that entity awards a share-based payment to an employee or other supplier of goods or services for the entity’s benefit. Also called share-based compensation transactions.
Standard Antidilution Provisions
Standard antidilution provisions are those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction that are designed to maintain the value of the conversion option.
Stock Dividend
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 give the recipient shareholders some ostensibly separate evidence of a part of their respective interests in accumulated corporate earnings without distribution of cash or other property that the board of directors deems necessary or desirable to retain in the business. A stock dividend takes nothing from the property of the corporation and adds nothing to the interests of the stockholders; that is, the corporation’s property is not diminished and the interests of the stockholders are not increased. The proportional interest of each shareholder remains the same.
Stock Split
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.
Subsidiary
An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary beneficiary.)
Substantive Conversion Feature
A conversion feature that is at least reasonably possible of being exercisable in the future absent the issuer’s exercise of a call option.
Suspense Shares
The shares initially held by the employee stock ownership plan in a suspense account are called suspense shares. Suspense shares are shares that have not been released, committed to be released, or allocated to participant accounts. Suspense shares generally collateralize employee stock ownership plan debt.
Top-Up Shares
Top-up shares are shares or cash that an employer contributes to an employee
stock ownership plan because the fair value of the shares
released is less than the employer’s liability for a
particular benefit, such as a savings plan match.
Treasury Stock Method
A method of recognizing the use of proceeds that could be obtained upon exercise of options and warrants in computing diluted EPS. It assumes that any proceeds would be used to purchase common stock at the average market price during the period.
Vest
To earn the rights to. A share-based payment award becomes vested at the date that the grantee’s right to receive or retain shares, other instruments, or cash under the award is no longer contingent on satisfaction of either a service condition or a performance condition. Market conditions are not vesting conditions.
The stated vesting provisions of an award often establish the employee’s requisite service period or the nonemployee’s vesting period, and an award that has reached the end of the applicable period is vested. However, as indicated in the definition of requisite service period and equally applicable to a nonemployee’s vesting period, the stated vesting period may differ from those periods in certain circumstances. Thus, the more precise terms would be options, shares, or awards for which the requisite good has been delivered or service has been rendered and the end of the employee’s requisite service period or the nonemployee’s vesting period.
Warrant
A security that gives the holder the right to purchase shares of common stock in accordance with the terms of the instrument, usually upon payment of a specified amount.
Weighted-Average Number of Common Shares Outstanding
The number of shares determined by relating the portion of time within a reporting period that common shares have been outstanding to the total time in that period. In computing diluted EPS, equivalent common shares are considered for all dilutive potential common shares.
Appendix D — Titles of Standards and Other Literature
Appendix D — Titles of Standards and Other Literature
AICPA Literature
Technical Questions and Answers
Section 4210.04, “Accrual
of Preferred Dividends”
FASB Literature
ASC Topics
ASC 205, Presentation of
Financial Statements
ASC 220, Income Statement
— Reporting Comprehensive Income
ASC 230, Statement of
Cash Flows
ASC 235, Notes to
Financial Statements
ASC 250, Accounting
Changes and Error Corrections
ASC 260, Earnings per
Share
ASC 270, Interim
Reporting
ASC 350, Intangibles —
Goodwill and Other
ASC 450,
Contingencies
ASC 470, Debt
ASC 480, Distinguishing
Liabilities From Equity
ASC 505, Equity
ASC 718, Compensation —
Stock Compensation
ASC 740, Income
Taxes
ASC 810,
Consolidation
ASC 815, Derivatives and
Hedging
ASC 820, Fair Value
Measurement
ASC 825, Financial
Instruments
ASC 855, Subsequent
Events
ASC 946, Financial
Services — Investment Companies
ASUs
ASU 2020-06, Debt — Debt With Conversion
and Other Options (Subtopic 470-20) and Derivatives and Hedging —
Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for
Convertible Instruments and Contracts in an Entity’s Own Equity
ASU 2021-04, Earnings per
Share (Topic 260), Debt — Modifications and Extinguishments (Subtopic
470-50), Compensation — Stock Compensation (Topic 718), and Derivatives
and Hedging — Contracts in Entity’s Own Equity (Subtopic 815-40):
Issuer’s Accounting for Certain Modifications or Exchanges of
Freestanding Equity-Classified Written Call Options — a consensus of
the FASB Emerging Issues Task Force
Federal Regulations
IRC (U.S. Code)
Section 409A, “Inclusion in
Gross Income of Deferred Compensation Under Nonqualified Deferred
Compensation Plans”
Section 409(l),
“Qualification for Tax Credit Employee Stock Ownership Plans; Employer
Securities Defined”
Section 4501, “Repurchase of Corporate
Stock”
IFRS Literature
IAS 33, Earnings per
Share
IAS 34, Interim Financial
Reporting
SEC Literature
Accounting Series Releases (ASRs)
No. 142 (FRR Section
202.04), Reporting Cash Flow and Other Related Data
No. 268 (FRR Section 211),
Presentation in Financial Statements of “Redeemable Preferred
Stocks”
No. 280 (FRR Section 44),
General Revision of Regulation S-X
FRM
Topic No. 1, “Registrant’s
Financial Statements”
Topic No. 3, “Pro Forma
Financial Information”
Topic No. 7, “Related Party
Matters”
Topic No. 13, “Effects of
Subsequent Events on Financial Statements Required in Filings”
Final Rule Releases
No. 33-8176, Conditions
for Use of Non-GAAP Financial Measures
No. 33-10786, Amendments to Financial
Disclosures About Acquired and Disposed Businesses
No. 33-10890, Management’s Discussion and
Analysis, Selected Financial Data, and Supplementary Financial
Information
Regulation M-A
Item 1010(a), “Financial Statements;
Financial Information”
Regulation S-K
Item 10(a), “Application of Regulation
S-K”
Item 10(e), “Use of Non-GAAP
Financial Measures in Commission Filings”
Item 302, “Supplementary
Financial Information”
-
Item 302(a), “Supplemental Quarterly Financial Data”
Item 506, “Dilution”
Regulation S-X
Article 3, “Consolidated and
Combined Financial Statements”
Rule 5-02(27), “Balance
Sheets; Preferred Stocks Subject to Mandatory Redemption Requirements or
Whose Redemption Is Outside the Control of the Issuer”
Rule 6-11, “Financial
Statements of Funds Acquired or to Be Acquired”
Article 8, “Financial
Statements of Smaller Reporting Companies”
-
Rule 8-05, “Pro Forma Financial Information”
Rule 10-01, “Interim
Financial Statements”
-
Rule 10-01(b), “Other Instructions as to Content”
Article 11, “Pro Forma
Financial Information”
-
Rule 11-01, “Presentation Requirements”
-
Rule 11-02, “Preparation Requirements”
-
Rule 11-02(a), “Form and Content”
-
Rule 11-02(b), “Implementation Guidance”
-
SAB Topics
No. 1.B, “Financial
Statements; Allocation of Expenses and Related Disclosure in Financial
Statements of Subsidiaries, Divisions or Lesser Business Components of
Another Entity“
-
No. 1.B.1, “Costs Reflected in Historical Financial Statements”
-
No. 1.B.2, “Pro Forma Financial Statements and Earnings per Share”
-
No. 1.B.3, “Other Matters”
No. 3.A, “Senior Securities;
Convertible Securities”
No. 3.C, “Senior Securities;
Redeemable Preferred Stock”
No. 4, “Equity Accounts”
-
No. 4.B, “S Corporations”
-
No. 4.D, “Earnings per Share Computations in an Initial Public Offering”
-
No. 4.F, “Limited Partnerships”
No. 5, “Miscellaneous
Accounting”
-
No. 5.P, “Restructuring Charges”
-
No. 5.P.3, “Income Statement Presentation of Restructuring Charges”
-
-
No. 5.Q, “Increasing Rate Preferred Stock”
-
No. 5.T, “Accounting for Expenses or Liabilities Paid by Principal Stockholder(s)”
No. 6.B, “Interpretations of
Accounting Series Releases and Financial Reporting Releases; Accounting
Series Release 280 — General Revision of Regulation S-X: Income or Loss
Applicable to Common Stock”
No. 14.E, “Share-Based
Payment; FASB ASC Topic 718, Compensation — Stock Compensation, and Certain
Redeemable Financial Instruments”
Superseded Literature
Accounting Principles Board (APB) Opinion
APB 15, Earnings per
Share
AICPA Accounting Statements of Position
76-3, Accounting
Practices for Certain Employee Stock Ownership Plans
93-6, Employers’
Accounting for Employee Stock Ownership Plans
EITF Abstracts
Issue No. 89-8, “Expense
Recognition for Employee Stock Ownership Plans”
Issue No. 89-11, “Sponsor’s
Balance Sheet Classification of Capital Stock With a Put Option Held by an
Employee Stock Ownership Plan”
Issue No. 92-3, “Earnings
per Share Treatment of Tax Benefits for Dividends on Unallocated Stock Held
by an Employee Stock Ownership Plan (Consideration of the Implications of
FASB Statement No. 109 on Issue 2 of EITF Issue No. 90-4)”
Issue No. 07-4, “Application
of the Two-Class Method Under FASB Statement No. 128 to Master Limited
Partnerships”
Topic No. D-42, “The Effect
on the Calculation of Earnings per Share for the Redemption or Induced
Conversion of Preferred Stock”
Topic No. D-98,
“Classification and Measurement of Redeemable Securities”
FASB Concepts Statement
No. 6, Elements of
Financial Statements
FASB Staff Position (FSP)
Proposed No. FAS 128-a,
Computational Guidance for Computing Diluted EPS Under the Two-Class
Method
FASB Statements
No. 128, Earnings per
Share
No. 150, Accounting for
Certain Financial Instruments With Characteristics of Both Liabilities
and Equity
FASB Technical Bulletin
No. 97-1, Accounting
Under Statement 123 for Certain Employee Stock Purchase Plans With a
Look-Back Option
SEC SAB Topic
No. 48, “Transfers of
Nonmonetary Assets by Promoters or Shareholders”
Appendix E — Abbreviations
Appendix E — Abbreviations
Abbreviation
|
Description
|
---|---|
AICPA
|
American Institute of Certified Public
Accountants
|
AMEX
|
American Stock Exchange
|
APB
|
Accounting Principles Board Opinion
|
APIC
|
additional paid-in capital
|
ASC
|
FASB Accounting Standards Codification
|
ASR
|
Accounting Series Release
|
ASU
|
FASB Accounting Standards Update
|
CEO
|
chief executive officer
|
CFR
|
U.S. Code of Federal Regulations
|
DECS
|
debt exchangeable for common stock
|
EBIT
|
earnings before interest and taxes
|
EBITDA
|
earnings before interest, tax, depreciation,
and amortization
|
EITF
|
Emerging Issues Task Force
|
EPS
|
earnings per share
|
EPU
|
earnings per unit
|
ERISA
|
Employee Retirement Income Security Act of 1974
|
ESOP
|
employee stock ownership plan
|
ESPP
|
employee stock purchase plan
|
Exchange Act
|
Securities Exchange Act of 1934
|
FAS
|
FASB Statement of Financial Accounting
Standards
|
FASB
|
Financial Accounting Standards Board
|
Feline
|
flexible equity-linked exchangeable
|
FRM
|
SEC Division of Corporation Finance’s
Financial Reporting Manual
|
FRR
|
SEC Financial Reporting Release
|
FSP
|
FASB Staff Position
|
GAAP
|
generally accepted accounting principles
|
GAAS
|
generally accepted auditing standards
|
GP
|
general partner
|
IAS
|
International Accounting Standard
|
IASB
|
International Accounting Standards Board
|
IASC
|
International Accounting Standards
Committee
|
IDR
|
incentive distribution right
|
IFRS
|
International Financial Reporting
Standard
|
IPO
|
initial public offering
|
IRC
|
Internal Revenue Code of 1986
|
LLC
|
limited liability company
|
LP
|
limited partnership
|
MD&A
|
Management’s Discussion and Analysis
|
MEDS
|
mandatory enhanced dividend securities
|
MLP
|
master limited partnership
|
Nasdaq
|
National Association of Securities Dealers
Automated Quotations
|
NCI
|
noncontrolling interest
|
NYSE
|
New York Stock Exchange
|
OCA
|
SEC Office of the Chief Accountant
|
OTC
|
over the counter
|
PCAOB
|
Public Company Accounting Oversight
Board
|
PERCS
|
preferred equity redemption cumulative
stock
|
PIES
|
premium income equity securities
|
PIK
|
paid in-kind
|
PRC
|
The People’s Republic of China
|
PRIDES
|
preferred redemption increased dividend
equity securities
|
R&D
|
research and development
|
SAB
|
SEC Staff Accounting Bulletin
|
SEC
|
U.S. Securities and Exchange Commission
|
Securities Act
|
Securities Act of 1933
|
SOP
|
Statement of Position
|
SRC
|
smaller reporting company
|
TSR
|
total shareholder return
|
USD
|
U.S. dollar
|
VIE
|
variable interest entity
|
VSF
|
variable share forward
|
Appendix F — Roadmap Updates for 2023
Appendix F — Roadmap Updates for 2023
The table below summarizes the substantive
changes made in the 2023 edition of this Roadmap.
Section
|
Topic
|
Description
|
---|---|---|
Updated for 2023.
| ||
Dividends Paid in Shares of Preferred
Stock
|
Amended guidance on PIK dividends.
| |
Increasing-Rate Preferred Stock
|
Added guidance to clarify (1) the
application of SAB Topic 5.Q to convertible preferred stock
and (2) the relationship between SAB Topic 5.Q and the SEC’s
guidance on redeemable equity securities.
| |
Convertible Preferred Stock
|
Deleted guidance on beneficial conversion
features and moved guidance on down-round features to
Section 3.2.2.5.1.
| |
Redemption of Preferred Stock
|
Enhanced discussion by adding a table that
addresses the redemption of preferred stock, including
payment of excise taxes.
| |
Convertible Preferred Stock That Contains a
Separately Classified Equity Component
|
Deleted discussion of beneficial conversion
features.
| |
Redemption of Common Stock
|
Enhanced discussion of the repurchase of
stock for an amount that exceeds the quantity repurchased
times the quoted price. Amended Example 3-22.
| |
Excise Tax Obligations Arising From the
Repurchase of Common Stock
|
Added guidance on excise tax obligations
incurred in conjunction with the repurchase of common
stock.
| |
Freestanding Equity-Classified Contracts
Indexed to an Entity’s Preferred Stock
|
Deleted discussion of contracts that contain
a beneficial conversion feature.
| |
Convertible Debt That Contains a Separately
Classified Equity Component Indexed to an Entity’s Common
Stock
|
Deleted discussion of convertible debt
instruments that contain a beneficial conversion feature and
that are accounted for in accordance with the cash
conversion subsections of ASC 470-20, which have been
rescinded from U.S. GAAP.
| |
Convertible Preferred Stock That Contains a
Separated Equity Component Indexed to an Entity’s Common
Stock
|
Removed discussion of convertible preferred
stock that contains a beneficial conversion feature and made
conforming amendments to the remaining guidance.
| |
Down-Round Features in Freestanding Financial
Instruments | Removed discussion of the accounting before
ASU 2020-06. | |
Modification or Exchange of Other Potential Common Stock
|
Updated Table 3-8 to remove
discussion of the accounting before ASU 2021-04.
| |
Reclassification of Other Potential Common Stock
|
Amended Table 3-9 to remove
discussion of the cash conversion subsections of ASC 470-20,
which were rescinded by ASU 2020-06.
| |
Retirement-Eligible Employees
|
Added guidance on inclusion of shares in the denominator of
basic EPS in situations in which the shares will vest when
an employee becomes eligible to retire.
| |
Contingently Issuable Shares
|
Clarified that shares issuable solely upon the passage of
time are not contingently issuable and added guidance on
what constitutes a contingently issuable share under ASC
260.
| |
Background
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Scope
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Application of the Treasury Stock Method
|
Removed discussion of accounting before adoption of ASU
2020-06 throughout this entire section.
| |
Examples
| ||
Scope
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Application of the Reverse Treasury Stock Method
|
Removed discussion of accounting before adoption of ASU
2020-06 throughout this entire section.
| |
Prepaid Contracts
|
Amended guidance on the effect of prepaid written put options
on diluted EPS.
| |
Scope
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Application of the If-Converted Method
|
Removed discussion of accounting before adoption of ASU
2020-06 throughout this entire section.
| |
Examples
|
Removed discussion of accounting before
adoption of ASU 2020-06 from Example
4-13.
| |
Method of Settlement
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
General
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Examples
|
Clarified Example
4-19 and removed discussion of accounting
before adoption of ASU 2020-06 from Example
4-20.
| |
Contracts That May Be Settled in Stock or Cash
|
Removed discussion of accounting before adoption of ASU
2020-06 throughout this entire section.
| |
Distributions That Are Considered Issuances of Common
Stock
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
If-Converted Method
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Contracts That May Be Settled in Cash or Stock
|
Removed discussion of accounting before
adoption of ASU 2020-06 and clarified the application of the
numerator and denominator adjustments.
| |
General
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Basic EPS
|
Deleted discussion of convertible debt
instruments with beneficial conversion features from
Table 6-1.
| |
Background
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Basic EPS
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Diluted EPS
|
Removed discussion of accounting before adoption of ASU
2020-06 and deleted guidance that is no longer relevant
after adoption of ASU 2020-06.
| |
Diluted EPS
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Stock-Settled Debt
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Diluted EPS
|
Removed discussion of accounting for
Instruments C and X before adoption of ASU 2020-06.
| |
Embedded Conversion Option Is Separated Under ASC 815-15
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Convertible Debt Instrument Recognized at Fair Value
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Embedded Put Options
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Embedded Call Options
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Share-Based Payment Awards
|
Added Connecting
the Dots to address share awards to employees
who are eligible for retirement.
| |
Settlement in Shares or Cash
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Diluted EPS
|
Amended discussion to reflect adoption of ASU 2020-06.
| |
Convertible Preferred Stock
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Distributions That Are Considered Issuances of Common
Stock
|
Amended Example
8-4 to remove discussion of accounting before
adoption of ASU 2020-06.
| |
EPS Accounting
|
Removed discussion of accounting before adoption of ASU
2020-06.
| |
Convertible Debt
|
Removed discussion of disclosures before adoption of ASU
2020-06.
| |
Differences Between U.S. GAAP and IFRS Accounting
Standards
|
Updated to reflect the elimination of U.S. GAAP guidance
before the adoption of ASU 2020-06 and made other
changes.
| |
Pro Forma EPS in SEC Filings
|
Removed discussion of considerations before adoption of ASU
2020-06 and the impact of SEC Final Rule 33-10786, which is
effective for all entities.
|