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In certain instances, pro forma EPS may be required as discussed in the following sections.

7.7.1 Change in capital structure in conjunction with an IPO

If, in conjunction with an IPO, a conversion of outstanding securities (e.g., a conversion of preferred stock into common stock upon completion of the IPO) 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). If the conversion of outstanding securities does not result in a material reduction of EPS, the presentation of pro forma EPS giving effect to the conversion of outstanding securities is optional. See SEC FRM 3430.3.
Additionally, if a recapitalization transaction is determined to be more akin to the repurchase of equity interests through the issuance of new equity interests, and afforded prospective treatment in the EPS computation (as discussed in FSP 7.6.4), pro forma EPS giving effect to the exchange should be presented for the latest year and interim period.

7.7.2 EPS when dividends are paid from the proceeds of an IPO

A private company or subsidiary may use the proceeds of an IPO to pay a dividend to its promoters/owners or parent company. In some situations, the dividend may exceed earnings in the most recent year. In such a case, the reporting entity should include unaudited pro forma per share data (for the latest year and interim period only) on the face of the income statement, giving effect to the number of shares whose proceeds would be necessary to pay the portion of the dividend that exceeds the current year’s earnings.
The pro forma EPS requirement also applies to both of the following situations:
  • A dividend that is declared after the date of the latest balance sheet included in the registration statement if the dividend exceeds earnings for the previous twelve months
  • A planned (but not yet declared) dividend if the planned dividend exceeds earnings for the previous twelve months, even if the dividend will not be funded from the proceeds of the IPO (e.g., the dividends were/will be funded from the proceeds of a line of credit or cash on hand)
SEC FRM 3420.2 addresses the application of ASC 855-10-S99-1 (SAB Topic 1.B.3) when the dividend to be paid exceeds both the last twelve months’ earnings and the proceeds from the equity offering. In that instance, the pro forma EPS computation should not reflect more shares than will be outstanding after the offering.
To present a transparent picture for the investor in this case, reporting entities should also adjust the numerator of the pro forma EPS computation to reflect the incremental interest expense (net of tax) relating to the portion of the dividend that exceeds both the gross proceeds from the equity offering and the previous 12 months’ earnings, which would be assumed to be funded by debt.

7.7.3 Offerings involving debt or other capital retirements

SAB Topic 3.A reminds registrants of the pro forma requirements of S-X Article 11 in a registration statement of convertible preferred stock or debt when the proceeds will be used to extinguish existing preferred stock or debt and the extinguishments will have a material effect on EPS.
We believe that registrants should also consider the guidance in SAB Topic 3.A when there is an issuance of common stock with similar use of the related proceeds to retire preferred stock or debt. In this situation, the pro forma EPS calculations would be based on the shares outstanding prior to sale plus the shares required to be sold to raise the cash necessary to extinguish the preferred stock or debt (i.e., not necessarily the entire proposed issuance), calculated using the offering price per share to the public. Net income would be adjusted to eliminate the interest expense, net of related tax effect (or, in the case of preferred stock, net income attributable to common stockholders would be adjusted to eliminate the dividends on the preferred stock). The additional shares should be included for the elapsed time from the beginning of the period or the date of issuance of the preferred stock or debt, if later. If the proceeds of the offering exceed the preferred stock or debt to be extinguished, only the number of shares necessary to raise the proceeds to extinguish the preferred stock or debt would be included in the denominator. The amount of dividends or interest expense eliminated should be the amount actually attributable to the preferred stock or debt extinguished.
Another situation generally requiring pro forma EPS involves a newly formed corporate entity (e.g., a recently incorporated carve-out or leveraged buyout). The capital structure of such an entity often includes temporary or bridge financing. For example, for tax purposes a company may use preferred stock rather than debt as the bridge financing vehicle, which will be extinguished with the proceeds of a public equity offering.
Example FSP 7-21 illustrates the calculation of pro forma EPS when a registrant uses the proceeds from an offering to extinguish existing debt.
EXAMPLE FSP 7-21
Calculation of pro forma EPS - proceeds of common share offering used to extinguish debt
FSP Corp will offer 10,000 common shares at $10 per share for total proceeds of $100,000. At December 31 20X1, FSP Corp has net income of $100,000, weighted average shares outstanding of 20,000, and a reported basic EPS of $5.00. The tax rate is 30%.
With a portion of the proceeds from the offering, FSP Corp will extinguish $50,000 of its existing debt, of which $25,000 was issued on January 1, 20X1 and $25,000 was issued on July 1, 20X1. The interest rate is 10%, and interest expense for the year is $3,750.
How should FSP Corp calculate pro forma basic EPS?
Analysis
FSP Corp should calculate pro forma basic EPS as follows:
Step 1: Determine the weighted average shares for pro forma purposes (denominator)
Weighted average shares, as reported
20,000
Additional shares for debt being extinguished – January 1 issuance
$25,000 (amount of debt to be extinguished) / $10 (per share stock price) = 2,500 shares
The entire 2,500 shares are included in the calculation because the debt was outstanding for the entire fiscal year.
2,500
Additional shares for debt being extinguished – July 1 issuance
$25,000 (amount of debt to be extinguished) / $10 (per share stock price) = 2,500 shares
The 2,500 shares are weighted based on the period for which the debt was outstanding as follows: 2,500 shares x 6/12 (debt was outstanding for half the year) = 1,250 shares
1,250
Weighted average shares, as adjusted
23,750
Step 2: Determine the net income for pro forma purposes (numerator)
Net income, as reported
$100,000
Add back: Interest expense for the year related to debt to be extinguished, net of tax effects
$3,750 minus tax effects of $1,125 ($3,750 x 30% tax rate) = $2,625
$2,625
Net income, as adjusted
$102,625
Step 3: Calculate pro forma basic EPS
Net income, as adjusted
$102,625
Weighted average shares, as adjusted
23,750
Pro forma EPS – basic
$4.32
As illustrated above, the pro forma basic EPS calculation only includes the number of shares associated with the actual amount of debt being extinguished ($50,000) and not the entire share offering proceeds ($100,000).

7.7.4 Considerations in filings subsequent to an IPO

Pro forma earnings per share amounts generally should not be presented in the financial statements in subsequent Exchange Act filings (e.g. annual and interim filings on Forms 10-K and 10-Q), even if such amounts were included in the financial statements in the IPO registration statements.
See FSP 7.6.1 for guidance when presenting EPS in Exchange Act filings that gives effect to stock splits, reverse stock splits, stock dividends, and recapitalizations that were declared and effective in different reporting periods.
If the issuer was formerly a Sub-Chapter S corporation, partnership, or similar tax exempt enterprise, and voluntarily provided pro forma data (reflecting adjustments for taxes only) for all periods presented, the issuer should continue to present that pro forma data for periods prior to becoming a taxable entity (including the period of change) in subsequent Exchange Act filings, consistent with FSP 32.4.2.1. Such pro forma presentations should continue to calculate the pro forma tax expense based on statutory rates in effect for the earlier period. See SEC FRM 3410.1 and SEC FRM 3410.2.
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