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ASC 260-10-55-57 through ASC 260-10-55-59 (Example 4: Anti-dilution Sequencing) illustrates sequencing in the computation of diluted EPS (see FSP 7.5.1). Example FSP 7-18 also illustrates this concept, without using the re-allocation process described in FSP 7.5.8.
EXAMPLE FSP 7-18
Diluted EPS and the application of anti-dilution sequencing
FSP Corp has 10,000,000 shares of common stock and 2,000,000 shares of convertible preferred stock (issued at $10 par value per share) outstanding during 20X7 and has net income of $50,000,000.
Each share of preferred stock is convertible into two shares of common stock. The preferred stock is entitled to a cumulative annual dividend of $0.50 per preferred share (5% of the $10 par value), and then 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., on an "as-converted" basis).
For the year ended December 31, 20X7, dividends of $2 per share are paid to the common stockholders and, accordingly, participating dividends of $4 per preferred share are paid to the preferred stockholders, since each share of preferred converts into 2 common shares, in addition to the cumulative annual preferred dividend of $0.50. FSP Corp also has 1,200,000 stock options outstanding that were issued with an exercise price of $10 per share.
This example assumes that all compensation expense was recorded in prior years. The weighted average market price of FSP Corp's common stock for 20X7 is $15 per share.
How should diluted EPS be computed?
Analysis
Step 1: Allocate undistributed earnings under the two-class method
Net income
$50,000,000
Less: Dividends declared:
Common stock
20,000,000
Cumulative annual preferred stock dividend
1,000,0001
Participating preferred stock dividend
8,000,0002
Undistributed 20X7 earnings
$21,000,000
View table
1 2 million shares multiplied by $0.50 per share dividend
2 4 million “as-converted” shares of common stock [2 million preferred shares multiplied by 2 shares of common stock per share of preferred] multiplied by $2 per share dividend paid on common stock
Common stock
Preferred stock
Total
Distributed earnings
$20,000,000
$ 9,000,000
$29,000,000
Undistributed earnings
15,000,0001
6,000,0002
21,000,000
$35,000,000
$15,000,000
$50,000,000
View table
1 10 million common shares / (10 million + 4 million as-converted) = 71% multiplied by $21 million
2 4 million as-converted shares / (10 million + 4 million as-converted) = 29% multiplied by $21 million
Step 2: Calculate Basic EPS
Common stock
Preferred stock
Distributed earnings
$2.00
$4.50
Undistributed earnings
1.50
3.00
Basic EPS
$3.50
$7.50
View table
Step 3: Calculate the potential common shares related to options under the treasury stock method
Number of shares issued upon exercise
1,200,000
Less: shares repurchased with proceeds
Cash proceeds (1,200,000 multiplied by $10)
$12,000,000
Unamortized compensation cost 1
Total proceeds
$12,000,000
Divided by average stock price
$15
Shares repurchased
(800,000)
Incremental shares issued
400,000
View table
1 None in this example as all compensation cost was previously recorded.
Step 4: Determine the earnings per incremental share for each class of security
Add-back to income
Increase in number of common shares
Earnings add-back per incremental share
Options
0
400,000
Convertible preferred stock
$15,000,000
4,000,000
$3.75
View table
The security with the lowest earnings per incremental share has the most dilutive impact on EPS. In this case, the options are most dilutive, followed by the convertible preferred, so this is the sequence that is followed for determining diluted EPS.
Further, because the EPS associated with the convertible preferred stock is greater than basic EPS, the convertible preferred stock is considered anti-dilutive, as illustrated below.
Step 5: Compute diluted EPS
Income
Common shares
Diluted EPS
As reported for basic
$35,000,000
10,000,000
$3.50
Options
400,000
$35,000,000
10,400,000
$3.37 Dilutive
Convertible preferred stock
15,000,000
4,000,000
$50,000,000
14,400,000
$3.47 Anti-dilutive
View table
Because diluted EPSincreases from $3.37 to $3.47 when convertible preferred shares are included in the computation, the convertible preferred shares are anti-dilutive, and are excluded from the computation of diluted EPS. Therefore, diluted EPS is reported as $3.37.
This example illustrates the importance of following the proper sequencing when determining whether potential common shares are dilutive or anti-dilutive. If all potential common shares had been included in the diluted EPS computation without proper sequencing, it would have appeared that diluted EPS is $3.47, because $3.47 is dilutive versus the $3.50 computed for basic EPS. However, computing diluted EPS in the manner required by ASC 260 produces a more dilutive result, and the reporting entity reports $3.37.
Note: The emphasis in this example (FSP Example 7-18) is on anti-dilution sequencing. In addition, this example includes a participating security, but does not re-compute the allocation of undistributed earnings between the participating security and the common shares at each step in the sequencing process. FSP Example 7-19 illustrates the impact on diluted EPS when the allocation of undistributed earnings is re-computed at each step in the sequencing process. This is consistent with how the FASB proposed it in the exposure draft for FAS 128R.
Example FSP 7-19 illustrates the computation of diluted EPS under the two-class method (as proposed in the exposure draft to FAS 128R):
EXAMPLE FSP 7-19
Diluted EPS under the two-class method proposed in the exposure draft to FAS 128
FSP Corp has 10,000,000 shares of common stock and 2,000,000 shares of convertible preferred stock (issued at $10 par value per share) outstanding during 20X7 and has net income of $50,000,000.
Each share of preferred stock is convertible into two shares of common stock. The preferred stock is entitled to a cumulative annual dividend of $0.50 per preferred share (5% of the $10 par value), and then 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., on an “as-converted” basis).
For the year ended December 31, 20X7, dividends of $2 per share are paid to the common stockholders and, accordingly, participating dividends of $4 per preferred share are paid to the preferred stockholders, since each share of preferred converts into 2 common shares, in addition to the cumulative annual preferred dividend of $0.50.
FSP Corp also has 1,200,000 stock options outstanding that were issued with an exercise price of $10 per share.
This example assumes that all compensation expense was recorded in prior years. The weighted average market price of FSP Corp’s common stock for 20X7 is $15 per share.
How should diluted EPS be computed using the re-allocation methodology described in FSP 7.5.8?
Analysis
Step 1: Allocate undistributed earnings under the two-class method
Net income
$50,000,000
Less: Dividends declared:
Common stock
20,000,000
Cumulative annual preferred stock dividend
1,000,0001
Participating preferred stock dividend
8,000,0002
Undistributed 20X7 earnings
$21,000,000
View table
1 2 million shares multiplied by $0.50 per share dividend
2 4 million “as-converted” shares of common stock [2 million preferred shares multiplied by 2 shares of common stock per share of preferred] multiplied by $2 per share dividend paid on common stock
Common stock
Preferred stock
Total
Distributed earnings
$20,000,000
$9,000,000
$29,000,000
Undistributed earnings
15,000,0001
6,000,0002
21,000,000
$35,000,000
$15,000,000
$50,000,000
View table
1 10 million common shares / (10 million + 4 million as-converted) = 71% multiplied by $21 million
2 4 million as-converted shares / (10 million + 4 million as-converted) = 29% multiplied by $21 million
Step 2: Calculate Basic EPS
Common stock
Preferred stock
Distributed earnings
$2.00
$4.50
Undistributed earnings
1.50
3.00
Basic EPS
$3.50
$7.50
View table
Step 3: Calculate the potential common shares related to options under the treasury stock method
Number of shares issued upon exercise
1,200,000
Less: shares repurchased with proceeds
Cash proceeds (1,200,000 multiplied by $10)
$12,000,000
Unamortized compensation cost 1
Total proceeds
$12,000,000
Divided by average stock price
$15
Shares repurchased
(800,000)
Incremental shares issued
400,000
View table
1None in this example as all compensation cost was previously recorded.
Step 4: Determine the earnings per incremental share for each class of security
Add-back to income
Increase in number of common shares
Earnings add-back per incremental share
Options
0
400,000
Convertible preferred stock
$15,000,000
4,000,000
$3.75
View table
The security with the lowest earnings per incremental share has the most dilutive impact on EPS. In this case, the options are most dilutive, followed by the convertible preferred, so this is the sequence that is followed for determining diluted EPS.
Step 5: Compute diluted EPS
1: Re-allocate undistributed earnings to preferred stockholders after assumed exercise of options
4,000,000 if-converted shares / (10,000,000 + 4,000,000 if-converted + 400,000 incremental shares from options) = 28% multiplied by $21,000,000 = $5,833,333.33
2: Re-compute diluted EPS after the reallocation of undistributed earnings to preferred stockholders
Undistributed and distributed earnings to common stockholders
Common shares
Earnings per share
As reported-Basic
$35,000,000
10,000,000
$3.50
Add-back: Undistributed earnings allocated to preferred shares in basic computation
$6,000,000
Options
400,000
Less: Undistributed earnings reallocated to preferred shares
($5,833,333)
Subtotal
$35,166,667
10,400,000
$3.38 Dilutive
Add-back: Undistributed earnings re-allocated to preferred shares
$5,833,333
Add-back: Distributed earnings to preferred shares
$9,000,000
4,000,000
Total
$50,000,000
14,400,000
$3.47 Anti-dilutive
Because diluted EPS increases when convertible preferred shares are included in the computation, the convertible preferred shares are anti-dilutive, and are ignored in the computation of diluted EPS. Therefore, diluted EPS is reported as $3.38.
Summary of total amount allocated for diluted EPS purposes:
Common stock
Preferred stock
Total
Distributed earnings
$20,000,000
$9,000,000
$29,000,000
Undistributed earnings
$15,166,667
$5,833,333
$21,000,000
Total
$35,166,667
$14,833,333
$50,000,000
View table
Summary of diluted earnings per share amounts:
Common stock
Preferred stock
Distributed earnings
$1.92
$2.25
Undistributed earnings
$1.46
$1.46
Diluted EPS
$3.38
$3.71
View table
As the example demonstrates, when using the reallocation method proposed in the exposure draft to amend FAS 128, diluted EPS is $3.38 per common share, as opposed to $3.37 per common share. This incremental $0.01 per common share results from the reallocation of undistributed earnings performed under this method. Assuming that the options have been outstanding as common shares from the beginning of the period, the reallocation method proposed in the exposure draft to amend FAS 128 results in less undistributed earnings being allocated away from the common stock to the preferred stock, and, as a result, EPS per common share is higher.
Reporting entities using the two-class method for the first time may use the method of computing diluted EPS under the two-class method proposed in the August 2008 ED to FAS 128. However, reporting entities that have not historically used this two-class method should continue to compute diluted EPS in the manner they have historically applied.
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