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Certain debt instruments may allow the issuer, at its election, to settle in cash or shares upon conversion, redemption, or maturity. The guidance in this section would also apply to financial instruments classified as liabilities due to the application of other guidance, such as ASC 815 or ASC 480.
In accordance with ASC 260-10-45-45, the effect of potential share settlement should be included in the diluted EPS calculation (if the effect is more dilutive) for any instrument that contains a provision that requires or permits share settlement (regardless of whether the election is at the option of an entity or the holder, or if the entity has a history or policy of cash settlement). If the ability to settle an instrument in shares is based on achieving a substantive contingency based on an event or index other than the issuer’s stock price, see FSP 7.4.6.3.
However, there is an exception to this requirement for certain share-based payment awards classified as a liability because of the requirements in ASC 718-10-25-15 that can be settled in cash or shares at an entity’s option. Under this guidance, an entity that nominally has the choice of settling share-based payment awards in cash or shares but predominantly settles in cash, or usually settles in cash whenever a grantee asks for cash settlement, is viewed to have established a substantive liability and the share-based payment award is classified as such. In this case, the reporting entity is allowed to overcome the presumption that the contract will be settled in shares if past experience or a stated policy provides a reasonable basis to conclude that the contract will be paid partially or wholly in cash. The FASB included this exception in ASU 2020-06 (which retains historical guidance in effect prior to the issuance of ASU 2020-06) as it did not wish to reevaluate aspects of share-based payment awards.
Adjustment of numerator
For an instrument that is accounted for as a liability, or in some cases an asset, with changes in fair value recorded in earnings, the calculation of assumed share settlement for EPS purposes would include an adjustment of the diluted EPS numerator to eliminate the effects of the contract that have been recorded in net income (net of tax, if any), and an adjustment of the denominator to include the impact of the share-settled contract, if dilutive in the aggregate. However, in accordance with ASC 260-10-55-33, this adjustment to the numerator would not be made for liability-classified stock-based compensation awards with assumed share settlement. This is because even if the stock-based compensation award were equity-classified, the reporting entity would still be recording compensation cost.
If a reporting entity reports a net loss for the period, potential common shares are generally anti-dilutive. However, if the net loss includes a change in fair value gain on an instrument that is classified as an asset or liability, and share settlement is assumed, this could result in the instrument being dilutive because the reversal of a gain in the numerator creates a larger loss and potentially a larger loss per share. For the instrument to be dilutive, the fair value gain that is reversed in the numerator (i.e., the increase to the net loss) must exceed the impact of the potential common shares that are added to the denominator as a result of presumed share settlement. When evaluating whether the instrument is dilutive, the collective impact of both the numerator and denominator adjustments on diluted EPS should be considered, versus evaluating the impact to the numerator and denominator separately. Additionally, the reporting entity would not adjust the numerator of diluted EPS in such a situation unless the application of the treasury stock method to the options and warrants in question would result in incremental potential common shares.
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