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Certain debt instruments may allow the issuer, at its election, to settle in cash or shares. 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.
Under ASC 260-10-55-32 through ASC 260-10-55-36A, when the reporting entity has the choice, and controls the settlement method of a security, it should presume share settlement for EPS purposes. However, it may overcome this presumption, and assume cash settlement, when there is a past practice or substantive stated policy that provides a reasonable basis to believe that the contract will be paid partially or wholly in cash.
We understand the SEC staff looks to a number of factors in evaluating whether a reporting entity’s stated policy to cash-settle a portion of its convertible debt instruments is substantive, including:
  • Settlement alternatives as a selling point

    The extent to which the ability to share settle factored into senior management’s decision to approve the issuance of the instrument rather than an instrument that only allowed for cash settlement
  • Intent and ability to cash settle

    The extent to which the reporting entity has the positive intent and ability to cash settle the face value and interest components of the instrument upon conversion

    The reporting entity should consider both current and projected liquidity in determining whether positive intent and ability exists. Management’s representation attesting to the positive intent and ability to cash settle is also a factor.
  • Disclosure commensurate with the reporting entity’s intention

    The extent to which the disclosures included in current period financial statements, and those included in the instrument’s offering documents, acknowledge and support the reporting entity’s positive intent and ability to adhere to its stated policy
  • Past practice

    Whether the reporting entity has previously share-settled contracts that provided a choice of settlement alternatives
If the instrument provides the counterparty with the choice of settlement method, the reporting entity should use the more dilutive outcome each period (cash vs. shares); past experience or a stated policy is not determinative.
When computing the numerator in the diluted EPS computation, the reporting entity needs to make independent quarterly and year-to-date determinations of the most dilutive method of settlement, similar to the treatment of the convertible preferred stock in Example 1 of ASC 260-10-55-38 through ASC 260-10-55-50.
The computation of diluted EPS can be more complex if the presumption of how a contract will settle changes to cash settlement or vice versa. In these situations, the computation of diluted EPS should reflect the change in the settlement assumption on a prospective basis, and the change in presumption should be disclosed. If, subsequent to issuance, a reporting entity could overcome the share settlement presumption and assume cash settlement, the computation of diluted EPS would reflect the contract as share-settled up until the date the assumption was changed. Thereafter, EPS would reflect the contract as cash-settled. The ability to overcome the presumption of share settlement will become difficult if a reporting entity has a past practice of changing its assumption from cash settlement to share settlement.
Question FSP 7-4A discusses the assertion of cash settlement.
Question FSP 7-4A
A reporting entity issues a convertible debt instrument with a cash conversion feature that allows the reporting entity to settle the entire obligation, both the par value and the conversion spread value, in any combination of cash or stock upon conversion (i.e., Instrument X).

Can the reporting entity assert that the instrument will be fully settled in cash for purposes of its diluted EPS calculation?
PwC response
No. Generally, it would not be appropriate to assume that the entire instrument will be cash-settled for purposes of diluted EPS because the value of the conversion spread is limitless (i.e., there is no limit to how high the reporting entity’s stock price may rise), which would make it difficult for a company to assert that it would have the intent and ability to always settle the arrangement in cash.

Adjustment of numerator
For a security 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 mark-to-market 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 mark-to-market 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.
Reporting entities may treat such contracts differently for accounting recognition purposes and for EPS purposes. For example, certain contracts that provide the reporting entity with the choice of settlement method would be treated as equity instruments for accounting purposes. Regardless of the balance sheet classification, however, if the reporting entity has a past practice or stated policy of settling such contracts in cash, the EPS computations would assume cash settlement.
For contracts accounted for as equity that are treated as cash settled for EPS, the reporting entity should also adjust the numerator when computing diluted EPS to reflect the income or loss on the contract that would have resulted during the period if the contract had been reported as an asset or liability. These adjustments are only permitted to the extent that accounting for the instrument as equity versus an asset or liability has an effect on net income.
Example FSP 7-18A illustrates the impact of a liability-classified warrant on the computation of diluted EPS.
EXAMPLE FSP 7-18A

Determining whether cash or share settlement is more dilutive for a liability-classified warrant
FSP Corp has net income of $10 million for 20X7 and 1 million shares of common stock outstanding for the period.
FSP Corp has outstanding warrants to issue 50,000 shares of its common stock with a strike price of $10 per share. These warrants are liability-classified and are marked-to-market each reporting period. The after-tax mark-to-market adjustment related to the warrants is a $0.5 million charge for the period (the warrant’s fair value increased in the period, resulting in an income statement charge for FSP Corp), which is already reflected in the $10 million net income figure. The warrants were outstanding for the entire period.
FSP Corp has no other potential common shares. The average market price of the common stock during the period is $15. The holder of the warrants has the choice of settlement in cash or shares. FSP Corp believes, based on past experiences, that the warrants will be share-settled.
How should FSP Corp include the warrants in the diluted EPS computation for the period?
Analysis
For warrants that may be cash- or share-settled at the holder’s election, past experience or a stated policy for settlement is not relevant. Accordingly, EPS should be based on the more dilutive of the settlement alternatives. If the warrants are assumed to be cash-settled, diluted EPS for the period is $10 per share ($10 million net income / 1 million shares), as no adjustment is required to either the numerator or denominator.
If the warrants are assumed to be share-settled, diluted EPS for the period is $10.33 per share (calculated below), as both the numerator and the denominator should be adjusted for the assumed exercise.
Calculation of diluted EPS with assumed share settlement:
Net income
$10,000,000
Add back of MTM loss
500,000
Income available to common stockholders
$10,500,000
Common shares outstanding
1,000,000
Shares issued upon exercise of warrants
50,000
Less: shares repurchased with proceeds 1
(33,333)
Incremental shares issued
16,667
Weighted average shares outstanding
1,016,667
Diluted EPS
$10.33
1 Calculated as: [(50,000 warrants multiplied by the $10 strike price) / $15 average share price]
The warrants should be presumed to be cash-settled, as that is more dilutive.
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