Expand
Resize
Add to favorites
Basic EPS is computed as:
Income available to parent company common stockholders
(the “numerator”)
Weighted average number of common shares outstanding
(the “denominator”)
The numerator may be impacted by transactions with preferred stockholders (dividends, accretion, repurchases, etc.) and by the required allocation of income to other classes of securities with participation rights.
The denominator may be impacted by share issuances and repurchases, as well as certain forward share purchase agreements, vested restricted stock awards, and certain contingent share arrangements.

7.4.1 Numerator

As discussed in ASC 260-10-45-10, the starting point for the calculation of the numerator is income from continuing operations and net income (after allocation of income to noncontrolling interests under ASC 260-10-45-11A, if applicable). The reporting entity adjusts these amounts by deducting (1) dividends declared in the period on preferred stock (whether or not paid), and (2) cumulative dividends on preferred stock (whether or not declared), regardless of the form of payment of the dividends (e.g., cash, stock, or other assets).
When a dividend on preferred stock is paid in another class of stock, the reporting entity should record the fair value of the shares issued as a charge (debit) to retained earnings. See FG 7.7.1 for further information. As discussed in ASC 260-10-45-12, dividends declared on preferred stock that are payable in the reporting entity's common shares should be deducted from earnings available to common shareholders when computing earnings per share. Accordingly, an adjustment to net income for preferred stock dividends is required regardless of the form of the payment (whether the dividend is paid in cash, other assets, common shares, or additional preferred shares of the same or another class).
As discussed in ASC 260-10-45-11, when there is a loss from continuing operations or net loss, the adjustment for preferred dividends will increase the loss. Preferred dividends that are cumulative only if earned should be deducted only to the extent they are earned.
In addition, the reporting entity should deduct any amount of undistributed earnings allocated to participating securities from the numerator. See FSP 7.4.2 for details.
Figure FSP 7-3 illustrates a number of other adjustments to arrive at the numerator for basic EPS.
Figure FSP 7-3
Possible adjustments made in computing income available to common stockholders for basic EPS after adoption of ASU 2020-06 View image
Figure FSP 7-3A
Possible adjustments made in computing income available to common stockholders for basic EPS before adoption of ASU 2020-06

7.4.1.1 Adjustments for cumulative undeclared dividends

A reporting entity may not be required to record undeclared dividends on cumulative preferred stock in its accounting records (i.e., on the balance sheet or statement of stockholders’ equity). However, the absence of accounting for undeclared dividends on cumulative preferred stock does not change the requirement to include the cumulative undeclared dividends in the EPS computation as discussed in ASC 260-10-45-11.
There are two common situations when the accounting for the cumulative undeclared preferred dividends would differ from the EPS treatment. In these instances, the reporting entity is not required to record the accumulated undeclared dividends in its balance sheet but should still deduct the cumulative undeclared dividends from the EPS numerator.
  • Perpetual cumulative preferred stock

    Because there are no redemption features in perpetual preferred stock, the perpetual cumulative preferred stock is classified within permanent equity (see FSP 5.6.2). As such, no dividend entry is recorded on the balance sheet or the statement of stockholders’ equity for any undeclared dividends.
  • Contingently redeemable cumulative preferred stock
Typically, the redemption price of contingently redeemable preferred stock includes any cumulative dividends. However, because contingently redeemable preferred stock is not accreted to its redemption value unless it is probable of becoming redeemable (e.g., the contingent event is probable of occurring), when the contingent event is not probable of occurring, there is no entry to record the accretion of the cumulative dividend. In such cases, reporting entities should disclose why redemption of the security is not probable. When redemption becomes probable, the cumulative undeclared dividends would increase the mezzanine equity carrying value. Only dividends declared are reported as dividends payable.
If the reporting entity subsequently declares preferred dividends that accumulated over prior periods, it should only reduce the numerator by the dividends related to the current period, as the amounts related to the prior periods would have already been included in the EPS computations of the prior periods.

7.4.1.2 Adjustments for accretion or decretion of equity

The accretion or decretion of equity, such as mezzanine equity, should be considered in the calculation of the numerator.
The impact of accretion or decretion on the computation of EPS may vary depending on whether the mezzanine equity is common stock, preferred stock, or a noncontrolling interest in a subsidiary.
Impact of mezzanine equity in the form of common stock
ASC 480-10-S99-3A requires common stock reported as mezzanine equity that is redeemable at an amount other than fair value to be treated as having a right to distributions that differs from other common stockholders. As such, changes in the mezzanine carrying amount generally impact income available to common stockholders.
ASC 480-10-S99-3A, paragraph 21 (FN 17), provides two acceptable approaches for allocating earnings to a common security that is redeemable at other than fair value. A reporting entity should make an accounting policy election to either:
  • Treat the entire adjustment to the security’s carrying amount as being akin to a dividend, or
  • Treat the portion of the periodic adjustment to the security's carrying amount that reflects a redemption price in excess of the security’s fair value as being akin to a dividend.
The impact may result in either an increase or decrease in income available to common stockholders. However, under either approach, increases cannot exceed the cumulative amount previously reflected as a reduction of income available to common stockholders for that security.
For common stock that is redeemable at fair value, no adjustment to the EPS numerator is required because redemption at fair value is not considered an economic distribution different from other common stockholders.
ASC 480-10-S99-3A, paragraph 21 (FN 18), also states that common stock redeemable based on a specified formula is considered to be redeemable at fair value if the formula is designed to approximate fair value. However, a formula based on a fixed multiple of EBITDA does not approximate fair value, as the appropriate multiple for determining fair value may change over time.
Example FSP 7-1 illustrates how to calculate income available to common stockholders when mezzanine equity in the form of common stock is redeemable for cash at an amount other than fair value.
EXAMPLE FSP 7-1

Accretion of mezzanine common stock in the calculation of the numerator for basic EPS
FSP Corp has 200 outstanding shares of common stock. One hundred shares of the common stock are redeemable for cash at an amount other than fair value.
During the reporting period, there is a $100 increase in the redemption value of the stock ($20 of which is in excess of changes in the stock’s fair value) and income of $500.
How should FSP Corp determine the numerator for basic EPS?
Analysis
The numerator depends on FSP Corp’s accounting policy choice. If FSP Corp elects to treat the entire adjustment as being akin to an actual dividend, the numerator would be $400 ($500 less $100). If it elected to treat only the portion of the periodic adjustment to the instrument’s carrying amount that reflects a redemption in excess of fair value as being akin to an actual dividend, the numerator would be $480 ($500 less $20).

Impact of mezzanine equity in the form of preferred stock
Any accretion or decretion of preferred stock classified as mezzanine equity should reduce or increase the numerator. Decretion can only be recorded to the extent of prior accretion on that instrument, until actual redemption occurs (see FSP 7.4.1.3 for guidance after adoption of ASU 2020-06 and FSP 7.4.1.3A for guidance before adoption of ASU 2020-06).
Impact of mezzanine equity in the form of a noncontrolling interest in a consolidated subsidiary
The same EPS concepts for parent-issued common and preferred mezzanine equity apply to noncontrolling interests in the form of common and preferred equity.
For mezzanine equity-classified noncontrolling interests in the form of preferred stock, presentation of the impact to the numerator may vary, depending on the terms of the redemption feature. If the redemption feature in the preferred securities is issued or guaranteed by the parent, the resulting increases or decreases in the carrying amount of the redeemable noncontrolling interest are treated in the same manner for EPS purposes as dividends on nonredeemable preferred stock of the parent. Therefore, the entire amount of increases or decreases in the carrying amount of a redeemable preferred stock will reduce or increase the numerator in the computation of the parent’s EPS, although increases to the numerator cannot exceed prior decreases recorded for that security.
If the subsidiary must redeem the preferred security with no parent company guarantee, the adjustment is attributed to the parent and the noncontrolling interest in accordance with ASC 260-10-55-20 and Example 7 in ASC 260-10-55-64 through ASC 260-10-55-67. As explained in these references, the per-share earnings of the subsidiary are included in the consolidated EPS computations based on the consolidated group's holding of the subsidiary securities pursuant to the two-class method at the subsidiary level (see FSP 7.4.2).
For mezzanine equity-classified noncontrolling interests in the form of common stock, no adjustment is needed if the common stock is redeemable at fair value, as redemption at fair value is not considered an economic distribution different from other common stockholders. However, for mezzanine equity-classified noncontrolling interests in the form of common stock that is redeemable at a value other than fair value, the manner in which the adjustments affect the numerator may differ, depending on how a reporting entity accounts for the redemption feature in its calculation of net income attributable to the parent.
If the terms of the redemption feature are fully considered in the attribution of net income to the parent, the reporting entity would not adjust the numerator, as the redemption feature is already included in the attribution of net income. However, if the terms of the redemption feature are not considered in the attribution of net income, then the parent should adjust the numerator for the impact of the redemption feature using similar approaches as described above.

7.4.1.3 Redemption, induced conversion, or certain modifications of preferred stock–after adoption of ASU 2020-06

ASC 260-10-S99-2 notes that the EPS numerator should be adjusted for a redemption of preferred stock when the fair value of consideration paid upon redemption exceeds the carrying amount, net of its issuance costs, because the excess represents a return to preferred stockholders.
The calculation is as follows:
Fair value of consideration transferred
less
Carrying value, net of issuance costs
equals
Adjustment to numerator
When the consideration is less than the carrying amount, net of issuance costs, the reporting entity should add the difference to the EPS numerator. For example, this would apply when a redemption is effected at a discount to the carrying amount of the preferred security.
This 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. Example FSP 7-2 illustrates the impact of a redemption of preferred stock on the computation of basic EPS.
EXAMPLE FSP 7-2

Impact of redemption of preferred stock on the calculation of basic EPS
On January 1, 20X6, FSP Corp issued perpetual preferred stock that is convertible in four years. The par value (and issuance price) of the convertible preferred stock is $1 million. The par value is equal to the fair value at the date of issuance.
On December 31, 20X7, FSP Corp paid shareholders $1.2 million in cash to redeem the preferred stock.
What is the impact of the redemption of the convertible preferred stock on the calculation of basic EPS?
Analysis
The difference between the fair value of the consideration transferred to preferred stockholders less the carrying value of the preferred stock would be treated as a “deemed dividend” to preferred shareholders and would result in a reduction to the numerator in the computation of basic EPS.
In this example, the reduction to the numerator in the computation of basic EPS is determined as follows:
Fair value of consideration transferred
$1,200,000
Less: Carrying value of preferred stock
(1,000,000)
Reduction in numerator related to “deemed dividend”
$200,000

If conditionally redeemable preferred shares, initially classified in mezzanine equity, are subsequently determined to be ASC 480 liabilities due to a change in facts (such as the exercise of a holder put feature), such shares would require reclassification from mezzanine equity to a liability. ASC 480-10-30-2 requires the issuer to measure the liability initially at fair value and reduce equity by the amount of the initial measurement, recognizing no gain or loss in the income statement. This reclassification of shares to a liability is akin to the redemption of such shares by the issuance of debt.
Similar to the accounting for the redemption of preferred shares in ASC 260-10-S99-2, if the fair value of the liability differs from the carrying amount of the preferred shares upon reclassification, the reporting entity should deduct the difference from, or add to, the numerator (i.e., as a deemed dividend or as a return from preferred stockholders).
ASC 810-10-40-2 provides guidance on the accounting for a redemption of a subsidiary's preferred stock, either directly by the subsidiary or by its parent, that is not classified as a liability in the parent's consolidated balance sheet. This type of transaction is treated in the parent's consolidated financial statements as an equity transaction and not recorded in the income statement. The related retained earnings charge or credit is reflected in EPS in the same manner described above.
While ASC 260-10-S99-2 states that the excess consideration requires an adjustment to the numerator, it does not address the treatment of the redemption of preferred stock of a subsidiary when that subsidiary's operations will be classified as a discontinued operation. We believe that, because the adjustment is directly associated with the subsidiary being discontinued, it should be attributed to discontinued operations in computing EPS. The impact of attributing the adjustment to discontinued operations could be meaningful because doing so would result in excluding this amount from the control number for purposes of determining whether potential common shares are dilutive or anti-dilutive in the computation of diluted EPS (see FSP 7.5.1).
Additionally, ASC 260-10-S99-2 indicates that in an induced conversion of preferred shares, the excess of the fair value of securities issued over the fair value of securities issuable pursuant to the original contractual conversion terms also represents a return to preferred stockholders and should reduce the numerator of EPS.
Lastly, as noted in FG 7.8.2, certain modifications of preferred stock can also result in an adjustment to the EPS numerator as a deemed dividend, based on the incremental fair value arising from the modification.

7.4.1.3A Redemption, induced conversion, or certain modifications of preferred stock–before adoption of ASU 2020-06

ASC 260-10-S99-2 notes that the EPS numerator should be adjusted for a redemption of preferred stock when the fair value of consideration paid upon redemption exceeds the carrying amount, net of its issuance costs, because the excess represents a return to preferred stockholders. Reporting entities should first deduct the commitment date beneficial conversion feature (BCF) related to the preferred stock from the fair value of consideration paid. See FG 7.9.2A and FG 7.10.1A for a more detailed discussion of beneficial conversion features in conjunction with the redemption or induced conversion of preferred stock.
The calculation is as follows:
Fair value of consideration transferred
minus
original BCF
less
Carrying value, net of issuance costs
equals
Adjustment to numerator
When the consideration is less than the carrying amount, net of issuance costs, the reporting entity should add the difference between the carrying amount, net of issuance costs, and the consideration to the EPS numerator. For example, this would apply when a redemption is effected at a discount to the carrying amount of the preferred security.
This 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. Example FSP 7-2A illustrates the impact of a redemption of preferred stock on the computation of basic EPS.
EXAMPLE FSP 7-2A

Impact of redemption of preferred stock on the calculation of basic EPS
On January 1, 20X6, FSP Corp issued perpetual preferred stock that is convertible in four years. The par value (and issuance price) of the convertible preferred stock is $1 million.
The convertible preferred stock also contains a beneficial conversion feature with an intrinsic value of $200,000 on the commitment date. The BCF is recorded as a discount on the preferred stock, with a related credit to APIC, and is being amortized to the first date at which the preferred stock is convertible.
On December 31, 20X7, FSP Corp paid shareholders $1.2 million in cash to redeem the preferred stock.
What is the impact of the redemption of the convertible preferred stock on the calculation of basic EPS?
Analysis
The difference between the fair value of the consideration transferred to preferred stockholders less the original BCF, and the carrying value of the preferred stock, including any unamortized discount related to the BCF, is treated as a “deemed dividend” to preferred shareholders and results in a reduction to the numerator in the computation of basic EPS.
In this example, the reduction to the numerator in the computation of basic EPS is determined as follows:
Fair value of consideration transferred
$1,200,000
Less: BCF (at original intrinsic value)
(200,000)
Less: Carrying value of preferred stock
(900,000)  1
Reduction in numerator related to “deemed dividend”
$100,000
View table
1 $1,000,000 par value less $100,000 remaining discount associated with the BCF.
Note that the accounting model for reacquisition of debt securities that contain a BCF and its impact on the gain/loss on extinguishment in ASC 470-20-40-3 differs from that of preferred stock, which is addressed in ASC 260-10-S99-2 (see FG 7.10.1A).

If conditionally redeemable preferred shares, initially classified in mezzanine equity, are subsequently determined to be ASC 480 liabilities due to a change in facts (such as the exercise of a holder put feature), such shares would require reclassification from mezzanine equity to a liability. ASC 480-10-30-2 requires the issuer to measure the liability initially at fair value, and reduce equity by the amount of the initial measurement, recognizing no gain or loss in the income statement. This reclassification of shares to a liability is akin to the redemption of such shares by the issuance of debt.
Similar to the accounting for the redemption of preferred shares in ASC 260-10-S99-2, if the fair value of the liability (less any initial BCF on the preferred stock) differs from the carrying amount of the preferred shares upon reclassification, the reporting entity should deduct the difference from, or add to, the numerator (i.e., as a deemed dividend or as a return from preferred stockholders).
ASC 810-10-40-2 provides guidance on the accounting for a redemption of a subsidiary's preferred stock, either directly by the subsidiary or by its parent, that is not classified as a liability in the parent's consolidated balance sheet. This type of transaction is treated in the parent's consolidated financial statements as an equity transaction and not recorded in the income statement. The related retained earnings charge or credit is reflected in EPS in the same manner described above.
While ASC 260-10-S99-2 states that the excess consideration requires an adjustment to the numerator, it does not address the treatment of the redemption of preferred stock of a subsidiary when that subsidiary's operations will be classified as a discontinued operation. We believe that, because the adjustment is directly associated with the subsidiary being discontinued, it should be attributed to discontinued operations in computing EPS. The impact of attributing the adjustment to discontinued operations could be meaningful because attributing it to discontinued operations would result in excluding this amount from the control number for purposes of determining whether potential common shares are dilutive or anti-dilutive in the computation of diluted EPS (see FSP 7.5.1).
Additionally, ASC 260-10-S99-2 indicates that in an induced conversion of preferred shares, the excess of the fair value of securities issued over the fair value of securities issuable pursuant to the original contractual conversion terms also represents a return to preferred stockholders and should reduce the numerator of EPS.
Lastly, as noted in FG 7.8.2, certain modifications of preferred stock can also result in an adjustment to the EPS numerator as a deemed dividend, based on the incremental fair value arising from the modification.

7.4.1.4A Adjustments related to beneficial conversion features–before adoption of ASU 2020-06

The guidance in this section is only applicable before the adoption of ASU 2020-06. A reporting entity should not apply this guidance after adoption of ASU 2020-06 as the beneficial conversion feature model is eliminated.
For convertible preferred securities, any amortization of the discount resulting from an allocation of proceeds to a beneficial conversion feature is analogous to a dividend. The reporting entity should recognize the amortization as a return to the preferred stockholders (a deemed dividend), following the guidance in ASC 470-20-30. The deemed dividend should be deducted from the numerator.
The reporting entity should also consider the deemed dividend when determining the dilutive impact of the convertible security in the computation of diluted EPS (see FSP 7.5.6A). That is, the adjustment to the numerator should be reversed if conversion is assumed.
For convertible debt securities, the discount created by recording the beneficial conversion feature represents an adjustment of the effective interest rate of the security, and the reporting entity should reflect it as a charge to interest cost.
For basic EPS, convertible debt  instruments with BCFs would not result in an adjustment to the numerator, as the interest cost is already included in net income. However, the interest on the debt (inclusive of amortization of the discount), net of associated tax, is added back to the numerator if the security is assumed to be converted for purposes of calculating diluted EPS (see FSP 7.5.6A).

7.4.1.5  Adjustments related to instruments with down round features–after adoption of ASU 2020-06

ASU 2020-06 eliminates the beneficial conversion feature model for both convertible preferred stock and convertible debt. Under the new guidance, convertible preferred stock is subject to the measurement provisions that require a reporting entity to record the value of the effect of a down round feature when it is triggered. Convertible debt continues to be excluded from the measurement provisions of the down round guidance because ASC 825 requires an issuer of convertible debt to disclose the fair value of the convertible debt (at the convertible debt instrument level) in the notes to the financial statements.
The ASC Master Glossary provides the following definition of a down round feature.

Definition from ASC Master Glossary

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.

Down round features are most often found in warrants and conversion options embedded in debt or preferred equity instruments issued by private reporting entities, but may also be found in financial instruments issued by public reporting entities. These features reduce the strike price of the instrument when an issuer sells shares of its stock (or issues equity-linked instruments) for amounts less than the current strike price (or with a strike price less than the current strike price).
When a down round feature is triggered (i.e., when the strike or conversion price is reduced) on an equity-classified freestanding financial instrument (e.g., a warrant) or an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated), reporting entities that present earnings per share must recognize the value of the effect of the down round feature as a deemed dividend. This value reduces the income available to common stockholders in the computation of basic earnings per share.
The value of the effect of the down round is calculated as the difference between (1) the fair value of the financial instrument (without the down round feature) with a strike price corresponding to the stated strike price of the issued instrument (that is, before the strike price reduction), and (2) the fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price. These fair values are determined as of the date the down round feature is triggered.

7.4.1.5A Adjustments related to instruments with down round features–before adoption of ASU 2020-06

The ASC Master Glossary provides the following definition of a down round feature.

Definition from ASC Master Glossary

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.

Down round features are most often found in warrants and conversion options embedded in debt or preferred equity instruments issued by private reporting entities, but may also be found in financial instruments issued by public reporting entities. These features reduce the strike price of the instrument when an issuer sells shares of its stock (or issues equity-linked instruments) for amounts less than the current strike price (or with a strike price less than the current strike price).
When a down round feature is triggered (i.e., when the strike price is reduced) on an equity-classified freestanding financial instrument (e.g., a warrant), reporting entities that present earnings per share must recognize the value of the effect of the down round feature as a deemed dividend. This value reduces the income available to common stockholders in the computation of basic earnings per share.
The value of the effect of the down round is calculated as the difference between (1) the fair value of the financial instrument (without the down round feature) with a strike price corresponding to the stated strike price of the issued instrument (that is, before the strike price reduction), and (2) the fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price. These fair values are determined as of the date the down round feature is triggered.
When a down round feature on an embedded conversion option (that is not separately accounted for) is triggered, the accounting guidance on contingent beneficial conversion features in ASC 470-20-25-20 must be considered.

7.4.1.6 Adjustments for equity-classified written call options

New guidance
In May 2021, the FASB issued 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). The ASU clarifies the guidance related to an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The amendments in the ASU are effective for all entities for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. Early adoption is permitted for all entities, including adoption in an interim period. If an entity elects early adoption in an interim period, the guidance should be applied as of the beginning of the fiscal year that includes that interim period.
If the modification or exchange of a freestanding equity-classified written call option is not within the scope of other guidance, a reporting entity shall apply the guidance in ASC 815-40-35-16 through ASC 815-40-35-18. Under this guidance, a reporting entity should recognize the effect of a modification or an exchange (as calculated below) in the same manner as if cash had been paid as consideration.
Modifications or exchanges that are not related to debt or equity financings, compensation for goods or services, or other exchange transactions within the scope of other guidance should be recognized as a dividend consistent with ASC 815-40-35-17(d). The dividend amount is measured as 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 in accordance with ASC 815-40-35-16. A reporting entity should deduct the effect of the modification or exchange (i.e., the dividend) in computing income available to common stockholders for basic earnings per share in accordance with ASC 260-10-45-15. See ASC 815-40-55-51 for an example of a warrant modification recognized as a dividend.

7.4.2 Participating securities and the two-class method

The capital structures of some reporting entities include participating securities. ASC 260-10-20 defines a participating security as follows:

Definition from ASC 260-10-20

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.

Examples of participating securities include:
  • Securities that participate in dividends with common stock according to a predetermined formula (e.g., two for one) with, at times, an upper limit on the extent of participation (e.g., 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 priority or senior rights.
In accordance with ASC 260-10-45-60A, any securities meeting the definition of a participating security, irrespective of whether the securities are convertible, nonconvertible, or potential common stock are included in the computation of basic EPS using the two-class method.

7.4.2.1 Overview of the two-class method

ASC 260 describes the two-class method as an earnings allocation formula.

Excerpt from 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…

The key to applying the two-class method in the computation of basic EPS is identifying any participating securities that are entitled to receive dividends if and when declared on common stock. These participating securities must be entitled to these rights in their current form (e.g., prior to exercise, settlement, conversion, or vesting).
The reporting entity is required to allocate any undistributed earnings between the common stockholders and the participating security holders based on their respective rights to receive dividends, as if all undistributed earnings for the period were distributed.
A participating security will reduce EPS regardless of whether dividends are actually paid, because the two-class method allocates earnings away from common stockholders to the participating security holders. This process is explained in FSP 7.4.2.2.
The reporting entity is not required to present basic and diluted EPS for participating securities, other than a second class of common stock, under the two-class method, but it is not precluded from doing so.
In some cases, a reporting entity may have two classes of common stock that have identical rights and privileges, except for voting rights. Generally, we believe the two classes can be combined and presented as one class for EPS purposes when the only difference is related to voting rights, but the classes otherwise share equally in dividends and residual net assets on a per share basis. In this situation, a reporting entity should clearly indicate that the earnings per share amounts reflect both classes of common stock, and should appropriately disclose the facts and circumstances in the footnotes.
Figure FSP 7-4 illustrates when and how to use the two-class method in computing basic EPS.
Figure FSP 7-4
EPS decision tree

7.4.2.2 Allocating undistributed earnings to participating securities

Reporting entities need to allocate undistributed earnings for the period to a participating security based on the contractual participation rights of the security to share in those earnings, as if all of the earnings for the period had been distributed. However, if the terms of the participating security do not specify objectively-determinable, nondiscretionary participation rights, undistributed earnings would not be allocated based on arbitrary assumptions.
In addition, if a reporting entity can avoid a distribution of earnings to a participating security, even when all of the earnings for the period are distributed, the reporting entity would not allocate undistributed earnings to that participating security.
The use of the two-class method requires an assumption of the hypothetical distribution of all earnings each period to all common stock and participating security holders according to the contractual terms of the securities. ASC 260-10-45-60B requires reporting entities to perform the hypothetical distribution of all earnings, regardless of whether those earnings would actually be distributed from an economic or practical perspective, and regardless of whether there are other legal or contractual limitations on its ability to pay dividends (e.g., debt covenants or state law considerations on the payment of dividends). The allocation of undistributed earnings is generally based on the weighted average number of common shares and participating securities outstanding for the period, not based on the shares or participating securities outstanding at the end of the period.
Question FSP 7-1 discusses the allocation of undistributed earnings when the entire class of participating securities is created, sold, converted, or redeemed during the period.
Question FSP 7-1
Does a reporting entity have to allocate undistributed earnings based on the weighted average number of common shares and participating securities outstanding for the period when the entire class of securities is created, sold, converted, or redeemed during the period?
PwC response
No. When an entire class of participating securities is created, sold, converted, or redeemed during the period, we believe a reporting entity has the option of performing a separate allocation of undistributed earnings for the pre- and post-transaction period as an alternative to the weighted average allocation. Under this method, net income for the pre- and post-transaction portions of the period are allocated to the securities outstanding during each respective portion of the period. This earnings allocation methodology may be used only if the underlying accounting systems and controls provide that the net income amount for each portion of the period reflects all appropriate entries that a normal close process would include. The allocation methodology is an accounting policy choice and should be consistently applied.

Question FSP 7-2 discusses the allocation of earnings for a more complex capital structure with a distribution “waterfall.”
Question FSP 7-2
In some entities (especially those with noncorporate structures), all distributions may follow a stated "waterfall" that requires that any distributions be first paid to Class A preferred unitholders until those holders receive a compounded cumulative annual return (e.g., 10%), as well as the return of all of their invested capital. Subsequent distributions are then paid to other unitholders, including common units.

In such a situation, in calculating earnings per share under the two-class method, does the hypothetical distribution of earnings in each period to all security holders following the terms of the organizing documents mean that all book net income up to the amount of invested capital of Class A preferred units should be allocated to the Class A preferred units, as that is how cash would be distributed?
PwC response
No. When considering the allocation of earnings between classes of securities, the focus is generally on the returnon capital of each security, not the returnof capital. As described above, the two-class method is an allocation of earnings of the reporting entity. This reflects the change in the net assets of the entity, and how each security holder shares in those increases and decreases. It is often the case that a reporting entity may be prohibited from paying any dividends on common stock while a class of preferred stock is outstanding. This effectively operates in a similar economic fashion as the situation described in the question but, as noted above, contractual limitations on the ability to pay dividends are ignored in the application of the two-class method.
Accordingly, we believe that in the above situation, earnings should generally be allocated first to the Class A preferred unitholders for their 10% cumulative dividends, and then shared between the common and preferred unitholders based on their right to receive dividends once dividends are being paid to the different classes. To do otherwise (i.e., to assume that all potential distributions would follow the waterfall and be used to repay the Class A preferred unitholders’ invested capital) would often allocate all earnings in all periods to the preferred unitholders (as each year is evaluated independently and if the principal is not actually paid, each year’s allocation would assume that the invested capital still needs to be paid), which we do not believe is consistent with the sharing of earnings (i.e., increases in net asset value) of the reporting entity between the classes of unitholders. The allocation of earnings for these reporting entities can be particularly complex in periods of loss, or in periods subsequent to periods of loss.

7.4.2.3 Allocating losses to participating securities

As noted in ASC 260-10-45-67 and ASC 260-10-45-68, a reporting entity should only allocate losses to convertible and nonconvertible participating securities if, based on the contractual terms of the participating securities, the securities have a contractual obligation to share in the losses of the reporting entity and the basis on which losses are shared is objectively determinable.
ASC 260-10-45-67 provides criteria to determine whether the holder of a participating security has a contractual obligation to share in the losses.
If a participating security is not required to share losses, it will not be allocated losses in periods of net loss, although it would be allocated earnings in periods of net income. Each reporting period should be evaluated independently; there is no cumulative “tracking” of the amounts allocated. Although this treatment is not symmetrical, it is consistent with the notion that EPS should reflect the most dilutive results. The reporting entity should determine whether a participating security holder has an obligation to share in its losses each period.
In computing year-to-date EPS, reporting entities should use year-to-date income (or loss) in determining whether undistributed earnings should be allocated to participating security holders. For example, if there is a quarter-to-date loss but year-to-date income for a given period, the year-to-date EPS computation should include an allocation to participating security holders even if the quarter-to-date computation did not.
We believe the discussion of allocating losses in ASC 260-10-45-67 and ASC 260-10-45-68 was written in the context of preferential securities. If the participating security is a second class of common stock (such as a nonvoting class with different dividend rates) that shares equally in residual net assets, losses would generally be allocated equally to each class of common stock.
Example FSP 7-3 illustrates how to apply the two-class method to participating securities.
EXAMPLE FSP 7-3

Application of the two-class method of EPS
FSP Corp has 10 million shares of common stock and 2 million shares of convertible preferred stock (issued at $10 par value per share) outstanding.
FSP Corp’s net income is $50 million.
Each share of preferred stock is convertible into 3 shares of common stock.
The preferred stock participates on a 1:1 basis in any common dividends that would have been payable had the preferred stock been converted immediately prior to the record date of any dividend declared on the common stock (i.e., as-converted basis).
At year-end, FSP Corp pays dividends of $2 per share to the common stockholders and $6 per share to the preferred stockholders, since each preferred share converts into 3 common shares.
How would FSP Corp compute basic EPS under the two-class method?
Analysis
Step 1: Calculate the undistributed earnings
Net income
$50,000,000
Less dividends declared:
Common stock
($20,000,000) 1
Participating preferred stock
(12,000,000) 2
(32,000,000)
Undistributed earnings
$18,000,000
1 10 million shares x $2 dividend/share
2 2 million preferred shares x $6 dividend per preferred share
Step 2: Allocate undistributed earnings to the two classes
To common:
[(Common shares outstanding) / (common shares outstanding + “as converted” shares of preferred)] x undistributed earnings
[(10,000,000) / (10,000,000 + 6,000,000)] x $18,000,000 = $11,250,000
To preferred:
[(“As-converted” common shares) / (common shares outstanding + “as converted” shares of preferred)] x undistributed earnings
[(6,000,000) / (10,000,000 + 6,000,000)] x $18,000,000 = $6,750,000
Step 3: Compute basic EPS for common stockholders
Net income
$50,000,000
Less: Earnings attributable to preferred stockholders
(18,750,000) 1
Income available to common stockholders
$31,250,000
Divided by common shares outstanding
10,000,000
Basic EPS
$3.13
View table
1 $12,000,000 dividend plus undistributed earnings of $6,750,000 allocated to preferred stockholders.

Allocating losses to restricted stock
Vested restricted stock may share in residual net assets because the fair value of the restricted stock would reflect any losses that have been incurred. However, unvested restricted shares do not share in residual net assets and, therefore, do not economically absorb the loss. As such, reporting entities should not allocate losses to unvested restricted shares.
Applying master limited partnership guidance to other types of corporate entities when allocating excess distributions
ASC 260 has certain provisions that specifically address the application of the two-class method to master limited partnerships when cash distributions exceed earnings for the period (see FSP 32 for further discussion). We believe this guidance may be applied by analogy to other types of corporate entities that have dividend distributions in excess of current period earnings. Therefore, in these situations, if the participating securities are contractually obligated to participate in the losses of the reporting entity, a portion of the excess distribution is allocated to these security holders based on their contractual participation in losses. If they do not participate in losses, all of the excess distribution is allocated to common stockholders.
Example FSP 7-4 illustrates how to apply the master limited partnership guidance when a reporting entity has participating securities and dividend distributions in excess of earnings.
EXAMPLE FSP 7-4

Allocating earnings to common shares when there are participating securities and dividends in excess of earnings
FSP Corp reports net income of $10 million in the quarter ended June 30, 20X7, and has 9.5 million shares of common stock outstanding.
FSP Corp has granted 1 million shares of unvested restricted stock to certain employees. The restricted stock is entitled to nonforfeitable dividends and, as such, is deemed to be a participating security. Requisite service is expected to be rendered for all shares of restricted stock.
During the quarter, FSP Corp pays dividends of $1/share, totaling $10.5 million ($9.5 million to the common stockholders and $1 million to the restricted stockholders).
How should FSP Corp allocate income to the common shares?
Analysis
By analogizing to the master limited partnership guidance, we believe FSP Corp generally should allocate the excess of distributions over earnings to the common shares, as the restricted shares have no obligation to participate in losses. As such, the excess of distributions over earnings would be allocated as follows:
Common stock
Restricted stock
Total
Distributed earnings
$9,500,000
$1,000,000
$10,500,000
Excess distributions
(500,000)
(500,000)
Net income
$9,000,000
$1,000,000
$10,000,000
View table

7.4.2.4 Allocating earnings in unusual circumstances

In a reporting period when there are different combinations of income and loss on different line items, and the participating securities are not contractually obligated to share in losses, there is no clear guidance in ASC 260 as to how earnings should be allocated to participating securities. We believe an acceptable approach is to allocate earnings to participating securities based on the “control number,” as discussed in ASC 260-10-45-18 and FSP 7.5.1.
The "control number" concept requires the use of income from continuing operations (adjusted for preferred dividends, as described in paragraph ASC 260-10-45-11) to determine whether potential common shares are dilutive or anti-dilutive. Applying this concept by analogy, if a reporting entity has income from continuing operations but losses from discontinued operations resulting in an overall net loss, it could allocate the loss using the two-class method. However, if there is a loss from continuing operations but income from discontinued operations results in overall net income, nothing would be allocated to participating securities for any of the categories.
Another acceptable method is to treat each line item as an independent calculation and only allocate earnings to participating securities for those line items for which income is reported. There would be no allocation of losses to participating securities for those line items for which a loss is reported.
For example, in a reporting period in which there is a loss from continuing operations, gain from discontinued operations and overall net income, we believe an acceptable approach is to not allocate losses from continuing operations to the participating securities, as the participating securities do not have a contractual obligation to participate in losses. However, the gain from discontinued operations and net income would be allocated to participating securities. Under this method, the sum of the individual EPS income statement line items would not reconcile to the total net income per share.
Other allocation methods may also be appropriate. The reporting entity should make and disclose an accounting policy election related to the allocation methodology and consistently apply the policy elected.

7.4.2.5 Other securities which may be considered participating

Consistent with ASC 260-10-45-60A, potential common shares (securities or other contracts that may entitle their holders to obtain common stock such as options, warrants, forwards, or other contracts) may be participating securities if, in their current form, they are entitled to receive dividends when declared on common stock.
Stock options, warrants, and other contracts to issue common stock
A nonforfeitable right to dividends is a non-contingent transfer of value and one in which paid dividends are not forfeited if the award does not vest. ASC 260-10-45-61A notes that an unvested share-based payment award that includes nonforfeitable rights to dividends or dividend equivalents meets the definition of a participating security in its current form—that is, prior to the requisite service having been rendered for the award.
ASC 260-10-45-68B discusses the computation of EPS when share-based payment awards with nonforfeitable rights to dividends or dividend equivalents are present. ASC 718, Compensation—Stock Compensation, requires reporting entities to recognize compensation cost for nonrefundable dividends or dividend equivalents paid on awards for which the requisite service is not (or is not expected to be) rendered (see SC 2.9.3.1). Dividends or dividend equivalents paid on awards for which the requisite service is (or is expected to be) rendered are charged to retained earnings. The dividends or dividend equivalents declared or paid and charged to retained earnings for these awards should be included in the earnings allocation to participating securities, reducing income available to common shareholders. A reporting entity should not include dividends or dividend equivalents that have been accounted for as compensation cost in the earnings allocation to participating securities because that amount has already reduced net income. However, reporting entities should allocate undistributed earnings to all outstanding share-based payment awards that have nonforfeitable rights to dividends (i.e., participating awards), including those for which the requisite service is not expected to be rendered as these amounts are not reflected in compensation cost but will still reduce what is available for common shareholders.
If a reporting entity changes the estimate of the number of awards for which the requisite service is not expected to be rendered, it should apply this change to the calculation of EPS in the period the change in estimate occurs. This change in estimate will affect compensation cost and, therefore, net income in the current period; however, a current period change in an entity's expected forfeiture rate would not affect prior period EPS computations. The example in ASC 260-10-55-76A through ASC 260-10-55-76D (Case D: Participating Share-Based Payment Awards) illustrates this.
Share-based payment awards that include forfeitable rights to dividends are not considered participating securities and should not be allocated undistributed earnings. However, similar to the guidance above for awards with nonforfeitable rights to dividends, the dividends or dividend equivalents actually declared or paid and charged to retained earnings for awards with forfeitable rights to dividends should also reduce income available to common shareholders. These amounts reflect dividends that have been paid to other-than-common-stockholders, and reduce the amount available for distribution to the common stockholders.
Convertible securities and options
Participation may not always involve the right to receive dividends in cash. For example, certain securities, including some share-based payment awards, do not pay dividends to the holders when declared on common stock. Instead, the conversion or exercise price of the security may be adjusted for dividends to keep the holder whole. In some cases, those adjustments may constitute participation rights.
If a convertible security has a mandatory conversion date, and if dividends or dividend equivalents are transferred to the holder of the convertible security in the form of a reduction of the conversion price or an increase in the conversion ratio of the security, then such feature would represent a participation right, because the transfer of value is not contingent on a decision to exercise (similar to a forward contract). In such cases, the reporting entity would reflect the participating feature in EPS as a participation right.
Dividends or dividend equivalents transferred to the holder of a convertible security in the form of an adjustment or reduction of the conversion price or an increase in the conversion ratio of the security do not represent participation rights if conversion is optional (i.e., at the election of either the holder or the reporting entity). This conclusion also applies to other securities that could be (but are not required to be) converted into a reporting entity's common stock (e.g., options or warrants), if those securities provide for an adjustment to the exercise price that is tied to the declaration of dividends by the issuer.
Since obtaining the benefit of an adjustment to the conversion or exercise price is dependent on the actual conversion or exercise of the security, which may or may not occur, these types of adjustments may not result in an actual transfer of value to the holder of the security (they are referred to as contingent transfers of value) and are, therefore, not a participation right. Accordingly, reporting entities should not allocate any undistributed earnings to these securities.
Forward contracts
In accordance with ASC 260-10-45-63, a provision in a forward contract to issue a reporting entity's own equity shares that reduces the contractual price per share when dividends are declared on the issuing entity's common stock is a participation right.

ASC 260-10-45-63

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.

Variable share-settled instruments (such as FELINE PRIDES, ACES and DECS)
Certain equity-linked securities involve arrangements with variable settlement features, referred to as “variable share forwards,” or “variable share forward delivery agreements.” These instruments are marketed by financial institutions under different proprietary names (e.g., FELINE PRIDES, ACES, and DECS).
Variable share forward delivery arrangements differ from fixed-term forwards through which the holder will always receive the benefit of dividends if declared (i.e., the transfer of value is non-contingent). Under variable share forwards, the holder is required to pay a certain amount of money to the reporting entity at the settlement date, and either of the following will occur:
  • If the reporting entity’s stock price at settlement falls within the established range, commonly referred to as the “dead zone,” there is no transfer of value, and the holder receives a variable number of shares of reporting entity stock with value equal to the contractual amount owed by the holder.
  • If the reporting entity’s stock price at settlement is above or below a certain range, the holder receives a fixed number of shares of reporting entity stock and realizes a benefit or loss.
The terms of these arrangements typically include a provision that, if the reporting entity declares a dividend on common stock while the arrangement is outstanding, the stock prices associated with the end points of the range, and the number of shares delivered when the stock price at settlement is outside of the range, are adjusted according to a formula. However, there is no adjustment to the number of shares delivered when the stock price at settlement is within the range.
Economically, these securities act as a combination of a written call option and a purchased put option, each with different strike prices. The issuer of a variable share forward delivery agreement should determine whether any adjustment provisions included in its contract convey a contingent or a non-contingent transfer of value for dividends declared. Generally, a variable share forward delivery agreement is not considered a participating security provided:
  • The agreement does not entitle the holder to participate in dividends if the final settlement is within the range; and
  • At issuance, it is at least reasonably possible that the final settlement of the contract will be at a price within the range.
To determine whether it is reasonably possible for a particular variable share forward delivery agreement to settle at a price within the dead zone, the reporting entity may need to perform a quantitative evaluation that incorporates:
  • The contractual terms of the agreement, including the method of adjusting for dividends and the maturity date,
  • Volatility of the issuer’s stock,
  • Historical and expected dividends, and
  • The width of the dead zone, and whether the issuer’s stock price is inside or outside the dead zone at issuance.
We believe the assessment as to whether these variable share forward agreements constitute participating securities need only be performed at issuance of the instrument, or upon a subsequent modification.
Mandatorily redeemable stock
Under ASC 480, Distinguishing Liabilities from Equity, mandatorily redeemable financial instruments are accounted for as liabilities. If these instruments have a right to dividends declared on the common shares, they are considered participating securities. Therefore, in computing the numerator, reporting entities should deduct any amounts, including contractual (cumulative) dividends and participation rights (e.g., of senior securities) in undistributed earnings that are attributable to mandatorily redeemable financial instruments (regardless of form), unless those amounts have already been recognized as interest in the income statement.

7.4.2.6 Targeted stock

Some registrants issue classes of stock that they characterize as “targeted” or “tracking” stock. The dividend rates associated with these classes of stock differ and are based upon the earnings of a specific business unit, activity, or assets of the registrant. As such, they are subject to the two-class method of ASC 260.
A reporting entity with targeted stock should ensure it is compliant with the contractual terms of the arrangement as to how the reporting entity's overall earnings would be allocated to the different classes of stock, especially if there are inter-unit transactions that are eliminated in consolidation. The total amount of earnings attributable to all the classes of stock under the two-class method for EPS purposes should be equal to consolidated income. In addition, EPS with respect to any class of the reporting entity's securities should be presented only in the reporting entity's consolidated financial statements, or in its related consolidated information, as that is the entity that issued the stock, and not the targeted business.

7.4.3 Denominator

The denominator of the basic EPS computation starts with the weighted-average number of common shares outstanding, which is defined in ASC 260-10-20.

Definition from ASC 260-10-20

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.

The number of weighted-average common shares outstanding is the average of shares outstanding and assumed to be outstanding (e.g., contingently issuable shares if the contingency has been met). While a daily calculation would be the most precise, other averaging methods may be used as long as they produce reasonable results. As noted in ASC 260-10-55-2, methods that introduce artificial weighting are not acceptable. The reporting entity should weight shares issued and shares reacquired during the period for the portion of the period they were outstanding.
Figure FSP 7-5 is a summary of selected securities that are excluded from the denominator of basic EPS, except as noted, and the section in this chapter where each security is discussed in detail.
Figure FSP 7-5
Selected securities excluded from the denominator of basic EPS
Type of security
Impact on denominator of basic EPS
Section
Contingent shares
Not included in the basic EPS denominator until the contingency has been resolved
Mandatorily convertible instruments
Not included in the basic EPS denominator
Prepaid variable share forward sale contracts
Variable shares in excess of the minimum number to be issued under the arrangement are not included in the basic EPS denominator.
Restricted stock-based compensation awards
Not included in the basic EPS denominator until vested, unless vesting occurs upon retirement and the employee is retirement eligible
Employee stock options
Not included in the basic EPS denominator
Mandatorily redeemable common stock
Not included in the basic EPS denominator if the stock is liability classified under ASC 480
Forward purchase contracts for a fixed number of shares
Shares subject to the forward purchase contract are not included in the basic EPS denominator if the forward purchase contract requires physical settlement of a fixed number of shares in exchange for cash.
Share lending arrangements
Not included in the basic EPS denominator unless default of the share lending arrangement occurs
Employee stock purchase plans
Typically not included in the basic EPS denominator until the shares are actually purchased

7.4.3.1 Contingent shares

In accordance with ASC 260-10-45-12C and ASC 260-10-45-13, contingently issuable shares, including shares issuable for little or no consideration, are included in the denominator for basic EPS only when the contingent condition has been met and there is no longer a circumstance in which those shares would not be issued. For example, if the issuance of shares were subject to a shareholder vote, they would not be included in EPS until the vote occurs. The shares are included in the computation of basic EPS as of the date that issuance of the shares is no longer contingent, even if the shares are not legally issued until a later date.
However, awards for which restrictions have lapsed, and shares to be issued to settle a deferred compensation obligation that may only be settled in shares (for example, Plan A in ASC 710-10-25-15), are included as outstanding shares for basic EPS.
Outstanding common shares that are contingently returnable are treated in the same manner as contingently issuable shares.

7.4.3.2 Mandatorily convertible instruments

In August 2008, the FASB issued an exposure draft (ED) that proposed amendments to FASB Statement No. 128, Earnings Per Share (FAS 128). The Basis for Conclusions of the ED stated that the shares to be issued upon conversion of a mandatorily convertible instrument should be included in basic EPS only if the holder has the present right or is deemed to have the present right to share in current-period earnings with common shareholders. Accordingly, mandatorily convertible instruments would only be included in the computation of basic EPS if they were considered participating securities.
Although the 2008 ED was never issued, we believe that the proposed guidance reflects the views of the FASB. As such, we believe that shares issuable pursuant to a mandatorily convertible security should not be included in the computation of the denominator of basic EPS. These shares should be included in the computation of diluted EPS using the if-converted method (see FSP 7.5.6 for guidance after adoption of ASU 2020-06 and FSP 7.5.6A for guidance before adoption of ASU 2020-06). Such shares would be included in the numerator of basic EPS only if the instrument was determined to be a participating security (see FSP 7.4.2).

7.4.3.3 Prepaid variable share forwards

Prepaid variable share forwards require a company to issue a variable number of shares at a future stipulated date. The number of shares to be issued is generally dependent on the volume weighted average price of the company's stock as of the stipulated date. Generally, there is a minimum number of shares that will be issued. The August 2008 ED to amend FAS 128 stated the following:

Excerpt from August 2008 proposed amendment to FAS 128

The Board agreed that including an instrument in basic EPS that does not give the holder the present ability to become a common shareholder provides an inaccurate depiction that, in all cases, the holder has the same claim to current-period earnings as a common shareholder even if the holder has stated participation rights that differ from common shareholders. Accordingly, the Board decided that the holder of (a) an instrument that is currently exercisable for little or no cost to the holder or (b) a share that is currently issuable for little or no cost to the holder has the present ability to become a common shareholder and, therefore, has the present right to share in current-period earnings with common shareholders.

Although there is some diversity in practice, we believe that the minimum number of shares issuable pursuant to this type of contract generally should be included in the weighted average number of shares outstanding in the computation of basic EPS. This is because they represent shares that have already been paid for and will be issued through only the passage of time at no additional cost to the holder.
In addition, we believe that any additional number of shares that would be issuable pursuant to the contract based on the period-end stock price, assuming the reporting date were the settlement date, should be included in diluted EPS as contingently issuable shares (see FSP 7.5.3). This is because the contract has been prepaid and the company has a contingent obligation to issue shares without additional consideration at a future date.
If the condition is based on an average of market prices over some period of time (e.g., a 10-day average), the corresponding average for the period (i.e., the 10 days leading up to the period-end date) should be used.

7.4.3.4 Restricted stock-based compensation awards

Unvested restricted stock or restricted stock units are excluded from the denominator of basic EPS, because the employee has not yet earned the shares (i.e., there is still a further “payment” in the form of future employee services). While the shares may be considered legally issued and outstanding under the terms of the restricted stock agreement, they are not considered issued for accounting purposes. However, if the reporting entity is required to issue shares to settle a restricted stock unit award, once the units are vested, the reporting entity includes the shares in basic EPS as of the vesting date, regardless of whether they have been legally issued. This is because the shares are considered issuable for little to no consideration under ASC 260-10-45-13 at this point. However, if either the reporting entity or the holder can elect cash or share settlement of the award, such awards should not be included in basic EPS, even if vested, as the reporting entity may not ultimately issue shares to settle the award.
Unvested restricted stock that must be settled in shares and is eligible for vesting upon an employee’s retirement is included in the denominator in the computation of basic EPS at the earlier of (1) the stated vesting date, or (2) the date the employee becomes eligible for retirement. At the date the employee becomes eligible for retirement, any remaining stated vesting period is considered nonsubstantive because issuance of the shares is not dependent on any service after that date.

7.4.3.5 Employee stock options

Stock options are excluded from the basic EPS denominator because they are not considered outstanding shares. The shares should be included in the denominator at the time of exercise.
Reporting entities should consider the substance, rather than the legal form, of all awards to determine the appropriate EPS treatment. For example, unvested stock options that allow the employee to “early exercise” but for which the reporting entity has the right to repurchase the shares at the exercise price (or the lesser of the current fair value or original exercise price) if the employee terminates employment prior to vesting should not be included in the basic EPS denominator prior to the stated vesting date. The shares issued upon early exercise are treated as contingently returnable pursuant to the guidance in ASC 260-10-45-13 and are still subject to a substantive vesting period. Therefore, these shares should not be included in basic EPS.

7.4.3.6 Common stock subject to repurchase

ASC 480-10-45-4 requires the following to be excluded from the denominator: (1) mandatorily redeemable shares of common stock requiring liability classification under ASC 480, and (2) shares of common stock subject to forward purchase contracts that require physical settlement of a fixed number of shares in exchange for cash. However, as described in ASC 480-10-45-4, any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to the shares to be repurchased that have not been recognized as interest costs should be deducted from income available to common shareholders pursuant to the two-class method of computing earnings per share. See FG 9.2.2.1 for further information on accounting for physically settled forward repurchase contracts.
Reporting entities may conclude that separately executed legal forward contracts with the same counterparty should be combined for accounting purposes. For example, when two or more forward contracts entered into in contemplation of each other with the same counterparty, including one that is for a fixed number of shares, together act as a forward contract on a variable number of shares, the shares underlying the forward contracts should be included in the denominator for basic EPS. This is because, in substance, the settlement is not in a fixed number of shares and so would not be excluded under the provision in ASC 480-10-45-4. Determining whether two or more forward contracts should be evaluated together is highly judgmental and should be carefully evaluated.
Forward purchase contracts that do not meet the criteria above impact the computation of the diluted EPS denominator under the guidance in ASC 260-10-45-35. See FSP 7.5.5.9 (after adoption of ASU 2020-06) or FSP 7.5.5.9A (before adoption of ASU 2020-06) for details

7.4.3.7 Share lending agreements

A reporting entity that is a convertible bond issuer may enter into a share lending agreement with an investment bank. A share lending agreement is intended to facilitate the ability of investors, primarily hedge funds, to borrow shares to hedge the conversion option in the convertible debt. These agreements are often executed when the issuer's stock is difficult or expensive to borrow in the conventional stock loan market.
Typically, share lending arrangements require the issuer to issue shares to the investment bank in exchange for a small fee, generally equal to the common stock's par value. In exchange, the investment bank promises to return the loaned shares to the issuer upon conversion or maturity of the convertible debt. The shares issued are legally outstanding, and are entitled to vote and receive dividends. However, under the terms of the arrangement, the investment bank may agree to reimburse the issuer for dividends received and may agree to not vote on any matters submitted to a vote of the reporting entity's stockholders.
ASC 470-20-45-2A states that loaned shares are excluded from EPS unless default of the share lending arrangement occurs, at which time the loaned shares would be included in the computation of basic EPS. If dividends on the loaned shares are not reimbursed to the reporting entity, the reporting entity would deduct any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to the loaned shares from the numerator, in a manner consistent with the two-class method (see FSP 7.4.2).
See FG 6.10.4A and FG 6.9.4 for a discussion of the recognition and measurement considerations of a share lending arrangement before and after adoption of ASU 2020-06, respectively.

7.4.3.8 Employee stock purchase plans (ESPPs)

Many companies offer ESPPs in which employees have a specified amount of their pay withheld for purposes of purchasing the reporting entity's shares at a discount to the then current fair value. These arrangements are typically considered a form of share-based compensation awards, as described in SC 5. The impact of these arrangements on EPS depends on whether the employees' participation can be revoked.
If employees can withdraw the amount of salary withheld during the offering period or must remain employed through the end of the offering period in order to purchase the shares, the arrangement is still an option or an unvested share-based compensation award through the end of the offering period. Until then, the shares calculated based on the employees’ withholding and the ESPP’s terms would not be included in the denominator of basic EPS. In such circumstances, the withholdings are a liability of the reporting entity that can be settled in cash or shares at the option of the employee. To be included in the basic EPS denominator, the shares have to be unequivocally issuable by the reporting entity.
If, however, the employee’s participation is irrevocable (even if employment was to terminate), the employee has no ability to obtain a refund of the amounts withheld, and the number of shares is fixed, there is no contingency. The reporting entity has received cash and has an irrevocable obligation to issue the shares. Therefore, the reporting entity would include the shares in the computation of basic EPS based on the amounts withheld and the ESPP’s purchase price formula.
In our experience, it is unusual for an ESPP to allow an employee to continue to participate in the plan after termination of employment; as a result, the employee is generally refunded any amounts withheld upon termination. Therefore, shares issuable under an ESPP are still dependent on continued employment and will typically not be included in basic EPS until the completion of the offering period, at which time the arrangement is fully vested and the number of shares to be issued are known. The potential shares should be considered for inclusion in diluted EPS, as described in FSP 7.5.5.5.

7.4.3.9 Penny warrants

As noted in ASC 260-10-45-13, shares issuable for little to no consideration should be included in the number of outstanding shares used for basic EPS (and therefore diluted EPS, as well, as shares included in basic EPS are never removed from the calculation of diluted EPS). There is no guidance on what is considered "little to no" consideration, and whether this literature should be applied to unexercised warrants or options. In their proposed amendments to pre-Codification FAS 128 (the source of ASC 260) in 2008, the FASB proposed that warrants or options exercisable for little to no cost (sometimes referred to as “penny warrants”) be included in the denominator of basic EPS (and therefore diluted EPS) once there were no further vesting conditions or contingencies associated with them. The vesting conditions are relevant as future service is considered a form of “consideration.” While the proposed amendments were not issued, we believe that this is the most current thinking of the FASB and that equity-classified penny warrants should generally be included in the computation of basic EPS. Contingent shares are not included in basic EPS until the contingency is resolved. Determination of what is considered little to no consideration still requires judgment, and would typically be assessed at the issuance (or grant) date of the instrument in relation to the stock price at that time.
However, liability-classified penny warrants (e.g., puttable penny warrants) generally should not be included in the weighted average number of outstanding shares for basic EPS. Liability-classified penny warrants generally would only be considered in the calculation of diluted EPS, unless they are also considered participating securities.
Expand

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

Your session has expired

Please use the button below to sign in again.
If this problem persists please contact support.

signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide