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.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.