When a reporting entity completes an IPO or a spin-off of either an existing subsidiary or a “carve-out” business, questions often arise as to how to compute EPS in the historical financial statements of the subsidiary or carve-out business.
In computing basic EPS for a carve-out business, the number of shares issued to the owner upon the legal formation of the entity that holds the business and contribution of that business to the entity is used as the denominator for all periods presented, akin to the treatment of a stock split. In this case, the number of shares issued simply reflects a recharacterization of the capital account previously held by the owner.
With respect to an existing subsidiary (i.e., an entity with a separate legal identity), the historical weighted average number of shares actually outstanding during each period is reflected in the denominator for all periods presented. However, issuance of shares to new investors in connection with the IPO/spin-off is treated prospectively from the issuance date. In connection with a stock split, EPS is restated for all periods presented. See FSP 7.6.1
In computing diluted EPS for a carve-out business or an existing subsidiary whereby parent options issued to employees are exchanged for options in the affiliate at the date of the IPO/spin-off, the dilutive effect of the affiliate options exchanged for the parent options is included in the affiliate’s denominator on a prospective basis. Previous periods are not affected, as the exchange of parent options for affiliate options is considered a modification of the terms of the original award. However, if the affiliate issues options and warrants to the parent company itself as part of the initial capitalization of the carved-out business, then the options are treated as if they were outstanding for all periods presented. It is also common for reporting entities to recapitalize or reorganize their legal entity structure in preparation for an IPO. There is limited guidance on such transactions. However, ASC 260-10-55-17
provides guidance on computing EPS in reorganizations.
When common shares are issued to acquire a business in a business combination, the computations of EPS shall recognize the existence of the new shares only from the acquisition date. In reorganizations, EPS computations shall be based on analysis of the particular transaction and the provisions of this Subtopic.
The reporting entity should evaluate the facts and circumstances of each situation when concluding on the appropriate EPS treatment. For example, some transactions may result in an exchange of equity interests, but no change in relative shareholder rights, rank, or value before and after the transaction. Such reorganizations may be equivalent to a stock split (simply changing the form of legal ownership to a new structure) and require retrospective treatment for EPS purposes, even if effected after the latest balance sheet date. Any financial statements issued, or SEC filings made, after the effective date of such an event should reflect the transaction retrospectively (i.e., it should be pushed back to prior periods).
In other transactions, often involving more complex capital structures, the reorganization transaction may affect a value-for-value exchange of equity interests at the point of the recapitalization, which results in a change in relative shareholder rights or rank before and after the transaction. This transaction may be more akin to the repurchase of equity interests through the issuance of new equity interests, and be afforded prospective treatment in the EPS computation.
If, in conjunction with an IPO, a conversion of outstanding securities will occur subsequent to the latest balance sheet date and the conversion will result in a material reduction of earnings per share (excluding effects of offering proceeds), pro forma EPS for the latest year and interim period should be presented giving effect to the conversion (but not the offering proceeds).
Question FSP 7-5 discusses the calculation of EPS in a common control merger.
Question FSP 7-5
Under ASC 805
, Business Combinations
, a common control merger is recorded at carryover basis, and the receiving entity reflects the acquired business for all prior periods (or since the date common control was obtained, if later), as if the entities had always been combined. How should the entity reflect the impact of the merger on EPS?
If the receiving entity issued shares to the stockholders of the contributing entity, this should be reflected in EPS in a similar fashion as a stock split (i.e., recharacterization of the historical common ownership) and reflected retrospectively for all periods presented under common control. The ratio of exchange of receiving entity shares issued for each share of the transferred entity should be multiplied by the weighted average number of shares and potential shares of the transferred entity for each reporting period, and added to the number of shares and potential shares of the receiving entity.
If the receiving entity paid cash to the stockholders of the contributing entity, there should generally be no impact to EPS. However, if the receiving entity issued shares to new investors to raise that cash, consideration should be given as to the treatment of the shares in the historical or pro forma EPS computations.