considers all convertible securities, including convertible debt and convertible preferred stock, which by their terms may be converted into common stock of the reporting entity, as potential common shares.
Share-settled convertible debt and convertible preferred stock are generally included in diluted EPS using the if-converted method as described in ASC 260-10-45-40
through ASC 260-10-45-42
Definition from ASC 260-10-20
If-converted method: A method of computing EPS data that assumes conversion of convertible securities at the beginning of the reporting period (or at time of issuance, if later).
The dilutive effect of convertible securities should be reflected in diluted EPS by application of the if-converted method as described in ASC 260-10-45-40
The dilutive effect of convertible securities shall be reflected in diluted EPS by application of the if-converted method. Under that method:
- If an entity has convertible preferred stock outstanding, the preferred dividends applicable to convertible preferred stock shall be added back to the numerator. The amount of preferred dividends added back will be the amount of preferred dividends for convertible preferred stock deducted from income from continuing operations (and from net income) in computing income available to common stockholders pursuant to paragraph 260-10-45-11.
- If an entity has convertible debt outstanding:
1. Interest charges applicable to the convertible debt shall be added back to the numerator. For convertible debt for which the principal is required to be paid in cash, the interest charges shall not be added back to the numerator.
2. To the extent nondiscretionary adjustments based on income made during the period would have been computed differently had the interest on convertible debt never been recognized, the numerator shall be appropriately adjusted. Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.
3. The numerator shall be adjusted for the income tax effect of (b)(1) and (b)(2).
- The convertible preferred stock or convertible debt shall be assumed to have been converted at the beginning of the period (or at time of issuance, if later), and the resulting common shares shall be included in the denominator. See paragraph 260-10-45-21A if the incremental shares are variable (such as when calculating a conversion premium).
When applying the if-converted method to convertible preferred stock, a reporting entity adds back the preferred dividends (declared or cumulative undeclared) applicable to the convertible preferred stock in the period to the diluted EPS numerator. Such add-back would also include any adjustments charged or credited to equity in the period to accrete preferred stock classified as mezzanine equity to its cash redemption price (or recorded upon a redemption or induced conversion), and any participating dividends allocated to the convertible preferred stock in the period for purposes of basic EPS.
A reporting entity with convertible debt outstanding will adjust the numerator for the income tax effect of interest charges and nondiscretionary adjustments, computed on a “with or without” basis. Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit sharing and royalty agreements.
The if-converted calculations are not affected by the reporting entity’s current stock price in relation to the conversion price. That is, a convertible security has the same effect on diluted EPS when the conversion option is far out of the money (i.e., the security has little chance of being converted), as it does when it is deep in the money (i.e., the security has a high likelihood of being converted).
In determining the common shares to be included in the denominator under the if-converted method, if the number of shares issuable upon conversion is variable, reporting entities should follow the guidance in ASC 260-10-45-21A
, which requires the use of the average market price when determining the number of shares that may be issued.
Convertible debt in which the principal amount must be settled in cash and the “conversion spread value” in shares (known in practice as an “Instrument C” bond) is included in diluted EPS using the if-converted method as described in ASC 260-10-55-84
through ASC 260-10-55-84B
. Specifically, there would be no interest expense adjustment to the numerator for the cash-settled portion of the instrument because that portion will always be settled in cash (see ASC 260-10-45-40
). Similarly, for convertible preferred stock for which the stated value is required to be paid in cash, a reporting entity should not add the preferred dividends back to the diluted EPS numerator in applying the if-converted method (by analogy to the convertible debt guidance in ASC 260-10-45-40(b)(1)
The denominator of diluted EPS for Instrument C is determined by dividing the “conversion spread value” of the share-settled portion of the instrument by the average share price over the reporting period. The “conversion spread value” is the value that would be delivered to investors in shares based on the terms of the bond upon an assumed conversion. In addition, for the purpose of determining the weighted average number of shares for the year-to-date diluted EPS computation for Instrument C, the number of incremental shares to be included in the denominator should be determined by averaging the number of incremental shares included in each quarterly diluted EPS computation.
The issuer of a debt instrument that may settle the bond upon conversion in any combination of cash or shares at the issuer’s option (known in practice as an “Instrument X” bond) must assume for purposes of the diluted EPS computation that the instrument is settled in shares. See FSP 18.104.22.168
When the conversion feature embedded in a convertible debt instrument is bifurcated from the debt host and accounted for separately pursuant to the derivative accounting literature, the debt host and the separated conversion feature (i.e., the embedded derivative) are each treated as a separate unit of account. The discount created on the debt by separation of the conversion feature should be amortized through interest expense over the life of the debt, and the conversion feature should be measured at fair value each reporting period with changes in fair value included in earnings.
Despite the fact that the debt and conversion feature are considered separate units of account for accounting purposes, they are treated as one instrument for EPS purposes (as it is a single convertible debt instrument) and included in the diluted EPS calculation using the if-converted method.
In addition to the adjustment for interest expense (which includes amortization of the discount created upon bifurcation of the conversion option from the debt), the change in fair value each period related to the bifurcated conversion option should be deducted from/added back to the numerator (adjusted for any tax effect) in calculating diluted EPS.
As discussed further in FSP 22.214.171.124
, ASC 260-10-55-32
requires reporting entities to exclude the income statement impact of instruments assumed to be settled in shares for EPS purposes and that are required to be reported as assets or liabilities, from the numerator in the diluted EPS calculation. The fair value adjustment is nondiscretionary in all periods, whether a gain or loss, and so should be deducted from/added to the numerator. As a result of the adjustments to the diluted EPS numerator for the interest expense and fair value gain or loss, and the denominator adjustment for the number of shares assumed to be converted, the security may be dilutive or antidilutive. If antidilutive, the security should be excluded from the diluted EPS calculation altogether.
If a reporting entity enters into an interest rate swap as a hedge of the interest associated with convertible debt that automatically terminates upon settlement or conversion of the debt (i.e., termination is nondiscretionary), the interest expense adjustment to the numerator is inclusive of the impact on interest expense arising from interest rate swaps formally designated as hedging instruments. If the swap arrangement does not automatically terminate upon conversion, the reporting entity should exclude the impact of the swap from the add-back, and add back only the contractual interest on the debt in the numerator.
Conversion is not assumed for purposes of computing diluted EPS if the effect would be anti-dilutive, such as in the following situations:
- Convertible debt is anti-dilutive when its interest and nondiscretionary adjustments (net of tax) per common share obtainable on conversion exceeds basic EPS.
- Convertible preferred stock is anti-dilutive when the amount of the dividend declared in, or accumulated for, the current period, including any deemed dividends or related accretion and participation in dividends, per common share obtainable on conversion exceeds basic EPS.
Similarly, in periods of net loss, the application of the if-converted method to convertible securities is generally anti-dilutive (see FSP 126.96.36.199
for a situation when it may not be).
Reporting entities should include convertible securities that have a dilutive effect on EPS in the denominator of diluted EPS from the beginning of the period or from the date of issuance, if later. They should also include dilutive convertible securities that are extinguished or redeemed, and securities in which the conversion options lapsed, in the denominator for the period they were outstanding. Consistent with ASC 260-10-S99-2, in circumstances when dilutive convertible securities are extinguished or redeemed and there is a gain or loss on extinguishment or induced conversion reflected in the numerator of basic EPS, the gain or loss should be reversed in the numerator of diluted EPS because the shares are assumed to have been converted at the beginning of the period.
Dilutive convertible securities converted during the period are included in the denominator of diluted EPS for the period prior to their conversion. Thereafter, the shares issued are included in the denominator of both basic and diluted EPS.
Example FSP 7-15 and Example FSP 7-16 illustrate the application of the if-converted method for convertible debt.
EXAMPLE FSP 7-15
Application of the if-converted method to convertible debt
On January 1, 20X7, FSP Corp issued $10 million of convertible bonds (10,000 bonds in $1,000 increments), at par. On the issuance date, FSP Corp’s common stock price was $100 per share. The terms of the bonds include:
- A coupon rate of 2% per year, which results in after-tax interest expense of $30,000 per quarter ($10 million x 2% x 1/4 = $50,000 less income tax of $20,000 (40% tax rate x $50,000)).
- A requirement that FSP Corp deliver 8 shares per bond to bondholders upon conversion (which equates to a conversion price of $125), or 80,000 shares (10,000 bonds x 8 shares per bond) in total.
FSP Corp has 10 million weighted average common shares outstanding, and net income for the quarter ended March 31, 20X7 is $50 million.
How should FSP Corp include the convertible bonds in the diluted EPS computation for the period ended March 31, 20X7?
FSP Corp should include the convertible bonds in diluted EPS using the if-converted method as follows.
Weighted average common shares and potential common shares
EXAMPLE FSP 7-16
Computing year-to-date diluted EPS when convertible debt is anti-dilutive in certain periods and dilutive in others
FSP Corp is profitable for the year but has net losses in the first and second quarters of 20X7. FSP Corp issued convertible debt in the prior year, which has been outstanding for all of 20X7.
When adding back interest expense on the convertible debt and adjusting the weighted average shares to reflect conversion at the beginning of those periods, the results are anti-dilutive for both the discrete quarters and for the year-to-date EPS computation for the first and second quarters. The result of assuming conversion in the third and fourth quarters is dilutive.
How would FSP Corp compute year-to-date EPS for the third and fourth quarters of 20X7?
For the nine- and twelve-month period computations, the assessment of whether the convertible debt is anti-dilutive should consider the entire period for which the convertible debt was outstanding (the nine- or twelve-month periods). The fact that there are discrete quarters in which the conversion was anti-dilutive does not matter, and those periods would not be excluded from the nine- and twelve-month year-to-date calculations. Example 1 (transaction e) in ASC 260-10-55
illustrates this point. Note: This would also be true if FSP Corp was profitable in all quarters, but the application of the if-converted method was still anti-dilutive in the first and second quarters due to the add-back per common share exceeding basic EPS. This is different than the treatment of treasury stock method shares in year-to-date diluted EPS computations, as described in FSP 188.8.131.52
Question FSP 7-3 addresses how a change in the conversion rate of convertible debt during a period should be reflected in diluted EPS.
Question FSP 7-3
In the second quarter, FSP Corp declared and paid a special dividend to holders of common stock. As a result, the conversion rate on FSP Corp's convertible notes was reduced in accordance with their contractual terms. How should the change in the conversion rate be treated for purposes of computing diluted EPS?
We believe that either of the following approaches would be acceptable.
- By analogy to ASC 260-10-45-42 (which addresses convertible securities issued, converted, or extinguished during the period), FSP Corp could calculate the number of shares to include in the denominator for the period by adding:
- the number of shares issuable based on the conversion rate in effect before the special dividend, weighted for that period, and
- the number of shares issuable based on the new conversion rate, weighted for the appropriate period.
- By analogy to ASC 260-10-45-52 (which addresses contingently issuable shares), FSP Corp could calculate the number of shares to include in the denominator for the period by using the number of shares issuable upon conversion determined solely by the end-of-period conversion price. This would reflect a maximum amount of dilution based on the number of shares that would be issuable as of the end of the period and going forward.
Choosing which approach to follow is an accounting policy decision and should be consistently applied in all periods for similar instruments.