7.5 Diluted EPS

Diluted EPS gives effect to all dilutive potential common shares outstanding during a period. The computation of diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. The potential common shares (as defined in ASC 260-10-20) are weighted for the period the instruments were outstanding (i.e., as of the beginning of the period or the date of issuance, if later).

Definition from ASC 260-10-20

Potential common stock: A security or other contract that may entitle its holder to obtain common stock during the reporting period or after the end of the reporting period.

This definition encompasses options, warrants, convertible securities, and contingent stock agreements.

In computing diluted EPS, reporting entities may have to adjust the numerator used in the basic EPS computation, subject to sequencing rules addressed in FSP 7.5.1, to make adjustments for any dividends and income or loss items associated with potentially dilutive securities that are assumed to have resulted in the issuance of common shares. ASC 260-10-55-32 indicates that these income or loss items should also include the fair value adjustments on instruments accounted for as liabilities, but which may be settled in shares that would result from the assumed issuance of potential common shares.

Because the numerator and denominator used for basic EPS are the starting point in computing diluted EPS, the concepts discussed in FSP 7.4 which address the computation of basic EPS remain relevant when computing diluted EPS.

Reporting entities should include dilutive instruments that are (1) issued, (2) expire unexercised, or (3) are cancelled during the period in the denominator of diluted EPS for the portion of the period they were outstanding.

Additionally, reporting entities should include dilutive instruments exercised during the period in the denominator of diluted EPS for the period prior to exercise. Thereafter, reporting entities include the actual shares issued in the denominator for both basic and diluted EPS.

7.5.1 Anti-dilution and sequencing – the control number concept

Computations of diluted EPS should generally not give effect to any individual class of potential common stock instrument for any period in which its inclusion would have the effect of increasing EPS (or decreasing the loss per share) otherwise computed (i.e., it is anti-dilutive).

Reporting entities use the control number concept to determine whether a potential common stock instrument is dilutive. The control number to be used is income/loss from continuing operations (adjusted for preferred dividends, as described in ASC 260-10-45-20). The control number concept requires that the same number of potentially dilutive securities applied in computing diluted EPS from continuing operations be applied to all other categories of income or loss, even if they would have an anti-dilutive effect on such categories.

For example, if a reporting entity were to report income from continuing operations, a loss from discontinued operations, and a net loss, the number of potential common shares used in the computation of diluted EPS from continuing operations would be used in determining diluted per share amounts of loss from discontinued operations and net loss, although this would result in reduced (or anti-dilutive) reported per share losses for those items.

In determining whether potential common shares are dilutive or anti-dilutive, the reporting entity should consider each issue or series of issues of potential common shares separately, rather than in the aggregate.

To reflect maximum potential dilution, the reporting entity should consider each issue or series of issues of potential common shares in sequence, from the most dilutive to the least dilutive (refer to Example 4 in ASC 260-10-55-57 through ASC 260-10-55-59). That is, dilutive potential common shares with the lowest earnings per incremental share are included in diluted EPS before those with higher earnings per incremental share. It would not be appropriate to simply calculate the impact of all potential common shares in the aggregate to determine if the end result is dilutive to basic EPS (see Example FSP 7-18).

7.5.2 Participating securities

Reporting entities should consider the effects of participating securities when computing diluted EPS. When there are participating securities, the computation under the two-class method for basic EPS may be more dilutive than the diluted EPS computation (using either the if-converted (see FSP 7.5.6 for guidance after adoption of ASU 2020-06 and FSP 7.5.6A for guidance before adoption of ASU 2020-06) or treasury stock method (see FSP 7.5.5), whichever is appropriate for that type of instrument). For example, the allocation of net income to a participating share of unvested stock that shares equally in all dividends with outstanding shares would be based on the full weighted-average number of unvested shares. However, the number of potential common shares that would be included for the unvested stock under the treasury stock method would be lower than the nominal number of shares because of the incorporation of unamortized compensation cost as "proceeds," as described at FSP 7.5.5. Therefore, the dilution to actual outstanding shares under the treasury stock method would be smaller than the dilution under the two-class method.

In these cases, because of the anti-dilution provision in ASC 260-10-45-17 through ASC 260-10-45-20, exercise or conversion should not be assumed. Rather, the allocation of earnings to participating security holders performed under the two-class method should be followed. Therefore, the numerator should be reduced for both basic and diluted EPS, and since the participating securities are not considered converted/exercised, the denominator should not be adjusted.

The impact of participating securities on the calculation of diluted EPS for other types of potential common shares is discussed at FSP 7.5.7 and FSP 7.5.8.

7.5.3 Contingently issuable shares

Shares (including those issued in connection with a business combination) whose issuance is contingent upon the satisfaction of certain conditions are considered outstanding and included in the computation of diluted EPS as follows:

• If all necessary conditions have been satisfied by the end of the period (the events have occurred), the shares are included in diluted EPS as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later). However, they would only be included in basic EPS from the date upon which the contingency was resolved.
• If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares to be included in diluted EPS is based on the number of shares, if any, that would be issuable if the end of the reporting period was the end of the contingency period if the result is dilutive (i.e., the number of shares that would be issuable based on current period earnings or period-end market price). These contingently issuable shares are included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).

General guidelines for the application of these principles for different types of contingencies are as follows:

• Specified amount of earnings

Outstanding common shares that are contingently returnable are treated in the same manner as contingently issuable shares.

Example FSP 7-8 illustrates the treatment of a business combination earn-out provision in the computation of diluted EPS.

EXAMPLE FSP 7-8
Impact of an earn-out based on earnings on diluted EPS when cumulative earnings fluctuate

An earn-out provision for a 20X6 business combination is payable in shares if cumulative earnings from the date of the business combination, January 1, 20X6, through December 31, 20X7 exceed a specified target.

Because of a loss in the first quarter of 20X7, cumulative results fall below the target at the end of that period.

The shares should be included in the denominator of diluted EPS from the beginning of the fourth quarter for 20X6. They would not be included in diluted EPS before that time. However, because cumulative results do not meet the target at the end of the first quarter of 20X7, the shares would not be included in that quarter's EPS computations and would not be included again until the earnings target is achieved. Prior period EPS should not be revised.

When the earn-out is classified as a liability but could (or must) be settled in shares, an adjustment also needs to be made to the numerator in the EPS calculation related to the impact of any mark-to-market adjustments. See FSP 7.5.6 for guidance after adoption of ASU 2020-06 and FSP 7.5.6A for guidance before adoption of ASU 2020-06.

For contingently issuable financial instruments other than shares (e.g., a contingently exercisable warrant or a share-based payment award with performance or market conditions), if the potential common shares may be assumed to be issuable based on the conditions specified for its issuance as described above, the impact on the computation of diluted EPS is determined by use of the treasury stock guidelines for options and warrants (see FSP 7.5.5.1), the if-converted method for convertible securities (see FSP 7.5.6 for guidance after adoption of ASU 2020-06 and FSP 7.5.6A for guidance before adoption of ASU 2020-06), or the provisions for contracts that may be settled in stock or cash (see FSP 7.5.7.1 for guidance after adoption of ASU 2020-06 and FSP 7.5.7.1A for guidance before adoption of ASU 2020-06), as appropriate.

7.5.3.1 Year-to-date computations for contingent shares

As noted in ASC 260-10-45-49, for year-to-date computations, contingent shares are included in diluted EPS on a weighted-average basis. That is, contingent shares are weighted for the interim periods in which they were included in the computation of diluted EPS. This methodology can result in a lack of comparability from quarter to quarter. Moreover, the sum of quarterly EPS data will not necessarily equal cumulative EPS data, and transactions considered dilutive or anti-dilutive in certain quarters may not be in other quarters. This is illustrated in ASC 260-10-55-50.

Example FSP 7-9 illustrates the treatment of contingent shares in the year-to-date diluted EPS computation when the contingency is met during the year.

An earn-out provision for a 20X6 business combination is payable in shares if cumulative earnings from the date of the business combination, January 1, 20X6, through December 31, 20X7 exceed a specified target.

The cumulative earnings target is first achieved in the 20X6 third quarter and remains above the threshold at December 31, 20X6.

In the year-to-date diluted EPS computation for 20X6, the shares associated with the earn-out would be included as if issued on the first day of the third quarter of 20X6 (not the first day of the year). The shares would also be included in the quarterly EPS computation for the third and fourth quarters of 20X6.

The shares would not be included in the quarterly or year-to-date EPS computations for either the first or second quarter of 20X6 as the earnings target was not being achieved at that time.

7.5.4 Diluted EPS computation methods

Figure FSP 7-6 summarizes which methods of including potentially dilutive securities in diluted EPS should be used for various securities after adoption of ASU 2020-06.

Methods of incorporating potentially dilutive securities in diluted EPS after adoption of ASU 2020-06

Figure FSP 7-6A summarizes which methods of including potentially dilutive securities in diluted EPS should be used for various securities before adoption of ASU 2020-06.

Methods of incorporating potentially dilutive securities in diluted EPS before adoption of ASU 2020-06

7.5.5 Treasury stock method

The treasury stock method considers the dilutive effect of issued, exercised, or expired options and warrants (and their equivalents) issued by a reporting entity in the computation of diluted EPS for the period they were outstanding. Equivalents include restricted stock, stock purchase contracts (e.g., forward sale contracts), and partially-paid stock subscriptions.

Definition from ASC 260-10-20

Treasury stock method: A method of recognizing the use of proceeds that could be obtained upon exercise of options and warrants in computing diluted EPS. It assumes that any proceeds would be used to purchase common stock at the average market price during the period.

Like other types of potential common stock, each issue or series of issues should be considered separately in determining whether potential common shares are dilutive or anti-dilutive.

A nonrecourse note issued by an option holder to the reporting entity to exercise the option should be treated as if the option remains outstanding. Accordingly, the nonrecourse loan amount should be considered as exercise proceeds in the application of the treasury stock method.

If the option holder issues a recourse note to the reporting entity to exercise the option, the reporting entity should perform additional analysis to determine the substance of the arrangement. The relevant factors are more fully described in SC 2.3.

7.5.5.1 Written options and warrants

Options and warrants that are equity-classified will be dilutive when the average market price of the common stock during the period exceeds the exercise price (i.e., they are “in-the-money”). Options and warrants that are liability-classified should be evaluated under the guidance in FSP 7.5.7.1 (after adoption of ASU 2020-06) or FSP 7.5.7.1A (before adoption of ASU 2020-06) pertaining to instruments settleable in cash or shares when their presumed exercise would result in incremental common shares.

• Assume exercise or settlement of the instrument at the later of the time of issuance or the beginning of the period
• Assume the proceeds from exercise or settlement have been used to repurchase the reporting entity’s common shares at their average market price during the period
• Include the incremental shares (shares assumed to be issued less shares assumed to have been repurchased) in the denominator

Example FSP 7-10 illustrates how to calculate the number of incremental shares that would result from the assumed exercise of warrants for purposes of computing diluted EPS under the treasury stock method.

FSP Corp has outstanding warrants to issue 500,000 shares of its common stock with a strike price of $10 per share. These options are equity classified (i.e., derivative accounting under ASC 815 is not required) and can only be settled in shares.

FSP Corp should include the incremental shares in the denominator of diluted EPS using the treasury stock method. The incremental shares are calculated assuming the warrants are exercised at the beginning of the period (or date of issuance of the warrant, if later), as follows:

Incremental shares = Common shares issuable upon exercise of warrants – shares assumed to be repurchased

The assumed proceeds under the treasury stock method are calculated differently for stock-based compensation awards. See FSP 7.5.5.5.

7.5.5.2 Purchased options

ASC 260-10-45-37 notes that purchased puts and calls held by the reporting entity on its own stock should not be included in the denominator of diluted EPS because inclusion would be anti-dilutive. The put options would be exercised only when the exercise price is higher than the market price, and the call option would be exercised only when the exercise price is lower than the market price. In both instances, their effect would be anti-dilutive under the treasury stock method and the reverse treasury stock method, respectively. The reverse treasury stock method is addressed in FSP 7.5.5.9 (after adoption of ASU 2020-06) or FSP 7.5.5.9A (before adoption of ASU 2020-06).

Reporting entities may enter into arrangements that include two contracts: (1) a separate purchased option, and (2) a written option. The changes in the value of the purchased option and written option may offset or hedge each other. We believe it would generally be inappropriate to combine the purchased option and the written option in the computation of EPS (this is consistent with pre-Codification FAS 128, paragraph 112 (Basis for Conclusions)), unless these transactions are otherwise combined for US GAAP. Conversely, if the reporting entity entered into a single contract for a net purchased option (such as a "capped call option"), exclusion from the EPS computations would generally be appropriate.

7.5.5.3 Options or warrants to purchase convertible securities

Written options or warrants to purchase convertible debt or preferred stock (that is classified as mezzanine equity) are liabilities under ASC 480-10-25-13.

Reporting entities should assume options or warrants to purchase convertible securities are exercised when the average prices of both the convertible security and the common stock obtainable upon its conversion are above the exercise price of the option or warrant.

However, reporting entities should not assume exercise unless they assume conversion of similar outstanding convertible securities, if any. After considering the anti-dilution sequencing rules, the reporting entity should determine the number of incremental shares of the convertible security (which will then be converted to common stock) using the treasury stock method similar to other options or warrants. There is no need to impute interest or dividends on the incremental shares, as these items would be reversed by the if-converted adjustments for the assumed conversions. See further discussion of conversion adjustments in FSP 7.5.6 (after adoption of ASU 2020-06) or FSP 7.5.6A (before adoption of ASU 2020-06).

7.5.5.4 Unit structures

In a unit structure, a reporting entity issues debt to an investment bank, which will be remarketed to investors at a date in the future, and concurrently issues a forward sale contract on its own shares. A unit structure is economically similar to convertible debt; however, unlike convertible debt, the forward contract for the reporting entity’s shares is legally detachable from the debt. Generally, the conversion option in convertible debt is not separable from the debt. Further, in the case of a unit structure, the debt often matures at a different (usually later) time than the forward contract does.

If the remarketing of the debt in the unit structure is successful, which is the expected outcome, the investor will use the cash received from the remarketing to settle the obligation under the forward. In the unlikely event of a failed remarketing of the debt, the debt is tendered by the holder as payment upon the exercise of the forward contract.

We believe the reporting entity should use the treasury stock method for the forward sale contract to compute diluted EPS if the chances of a failed remarketing are remote. In applying the treasury stock method, the reporting entity should determine the number of shares to be issued based on the average stock price and the terms of the forward contract.

The reporting entity should review the assumptions leading to this conclusion at the end of each reporting period. If the chance of a failed remarketing of the debt is no longer remote, the unit structure is, in effect, convertible debt under ASC 260-10-55-9. In that case, the reporting entity should use the if-converted method to compute diluted EPS, because the debt will be tendered by the investor in satisfaction of the investor’s obligation under the forward contract.

7.5.5.5 Stock-based compensation under the treasury stock method

The calculation of assumed proceeds under the treasury stock method for stock-based compensation awards requires additional considerations because the reporting entity receives the benefit of future service, which is considered additional proceeds.

• The exercise price of the stock options, if any
• Average unrecognized compensation cost for future service

Although compensation cost may only be recognized for awards that are expected to vest (determined by applying the pre-vesting forfeiture rate assumption), for those reporting entities that elect to estimate forfeitures, all options and shares outstanding that have not been forfeited are included in diluted EPS. In other words, the amount of stock-based compensation cost in the numerator may include a forfeiture rate assumption, while the number of shares in the denominator does not.

See Example FSP 7-11 for an illustration of the difference between the compensation cost recorded for share-based payment awards in the income statement and the amounts included in the assumed proceeds calculation.

Applying the treasury stock method to in-the-money options could be anti-dilutive if the sum of the proceeds, including the unrecognized compensation, exceeds the average stock price. In that case, those options would be excluded from the computation of diluted EPS. For example, if the average market price of the underlying stock was $12, an option with an exercise price of $10 (i.e., $2 in-the-money) and average unrecognized compensation for the period of $4 would be anti-dilutive because the assumed proceeds of $14 ($10 +$4) is greater than the average market price of the underlying share of $12. As a result, these awards are excluded from the diluted EPS denominator.

Stock options with service conditions are included in the computation of the denominator of diluted EPS using the treasury stock method if the option is dilutive. In computing diluted EPS, reporting entities should include all outstanding options that are dilutive, without considering the impact of a forfeiture-rate assumption applied for purposes of recognizing compensation cost under ASC 718.

Reporting entities should include stock options with performance or market conditions in the computation of diluted EPS if the options are dilutive and if their conditions (1) have been satisfied at the reporting date (the events have occurred), or (2) would have been satisfied if the reporting date was the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price). When making the determination, a reporting entity should not use projections that look beyond the current reporting period. In essence, it should follow the contingently issuable share guidance described in FSP 7.5.3.

For example, assume that a stock option has a performance condition under which the option vests when earnings before interest, taxes, depreciation, and amortization (EBITDA) reaches $15 million. At the end of the third quarter, EBITDA is $13 million and the company believes that EBITDA will be $17 million at the end of the year. The option would be excluded from the third quarter diluted EPS computation because the performance condition had not been achieved as of the end of that period, as required by ASC 260-10-45-51.

If the performance or market condition was satisfied or would have been satisfied if the performance or market metric was measured as of the reporting date, the stock options would be included in diluted EPS from the beginning of the period (or date of grant, if later) using the treasury stock method, if the option is dilutive.

Stock options often contain both performance and market conditions. If the award vests if either the performance or market condition is met, then assuming the options are dilutive, the award would be included in the computation of diluted EPS if either condition has been satisfied at the reporting date or would have been satisfied if the reporting date was the end of the contingency period. If both conditions must be met in order to vest, the award would be included in the computation of diluted EPS if the options are dilutive and both conditions have been satisfied at the reporting date or would have been satisfied if the reporting date was the end of the contingency period.

The accounting treatment for options with performance conditions under ASC 718 requires a probability assessment as to whether the option will vest; the accounting treatment under ASC 260 does not call for an assessment of the probability of vesting. Therefore, the numerator in the EPS computations may include compensation cost related to the performance awards, but the performance awards themselves may be excluded from the denominator. There are no adjustments made to the EPS numerator for such situations.

Example FSP 7-11 illustrates the impact of stock options granted to employees on the computation of diluted EPS.

On January 1, 20X7, FSP Corp grants employees 10,000 nonqualified stock options with an exercise price of $10. Each stock option has a $4 fair value at the grant date. 25% of the shares vest each year over a four-year period. The employee must be employed by the reporting entity on each vesting date to become vested in each tranche.

FSP Corp has elected a policy of straight-line attribution of compensation cost, and a policy of estimating forfeitures. The assumed forfeiture rate is 5% each year. No options were forfeited during 20X7.

The market price of the common stock is: $10 on January 1, 20X7; $26 on December 31, 20X7; $18 average for 20X7.

The treasury stock calculations use actual forfeitures rather than the forfeiture assumption used for compensation cost recognition purposes. The results of the calculations are hypothetical for EPS purposes and would not agree to the financial statement amounts. The calculations are only used to determine the number of options to include in the diluted EPS computation.

• Hypothetical total book compensation cost = $40,000

How many potential common shares should be included in diluted EPS for the year ended December 31, 20X7 for these stock options, assuming the shares are dilutive at the end of 20X7?

The options are included in the diluted EPS computation by applying the treasury stock method and assuming that the proceeds will be used to buy back shares. Proceeds equal the hypothetical average unrecognized compensation cost plus the exercise price.

• Hypothetical average unrecognized compensation cost for 20X7 = $35,000

A reporting entity should include both of the following in its computation of diluted EPS using the treasury stock method:

• Unvested restricted stock with service conditions
• Unvested restricted stock with a performance or market condition that is considered contingently issuable shares pursuant to ASC 260-10-45-48

Assumed proceeds under the treasury stock method consist of unamortized compensation cost. If dilutive, the unvested restricted stock would be considered outstanding as of the later of the beginning of the period or the grant date for diluted EPS computation purposes. If anti-dilutive, it should be excluded from the diluted EPS computation.

Example FSP 7-12, Example FSP 7-13, and Example FSP 7-14 illustrate the impact of restricted stock granted to employees on the computation of diluted EPS.

On January 1, 20X6, FSP Corp grants employees 10,000 shares of restricted stock with a fair value of $10 per share. The shares are legally issued and outstanding, and the employee is not required to pay for the restricted stock. All shares are expected to vest. The average stock price for the year ended December 31, 20X6 is $15 per share.

25% percent of the shares vest each year over a four-year period. The employee must be employed by the reporting entity on each vesting date to become vested in each tranche. The company has elected a policy of straight-line attribution and estimating forfeitures.

• Total book compensation cost = $100,000

How many shares are included in diluted EPS for the year ended December 31, 20X6, assuming the shares are dilutive at the end of 20X6?

The unvested shares are included in the diluted EPS computation by applying the treasury stock method and assuming that the proceeds will be used to buy back shares. Proceeds equal the average unrecognized compensation cost plus any purchase price.

• Average unrecognized compensation cost for 20X6 = $87,500

On January 1, 20X6, FSP Corp grants 10,000 shares of restricted stock with a fair value of $10 per share. The shares are legally issued and outstanding, and the employee is not required to pay for the restricted stock. All shares are expected to vest. The average stock price for the year ended December 31, 20X6 is $15 per share.

25% of the shares vest each year over a four-year period if certain performance conditions are met. The vesting provision includes a performance condition that requires the reporting entity's revenues to exceed $100 million in 20X6; $115 million in 20X7; $130 million in 20X8; and $145 million in 20X9 for the respective year's award to vest.

Each tranche is based on performance within that year; therefore, each tranche is treated as a separate award with a service inception date of January 1 of each year and a one-year requisite service period.

The reporting entity recognizes compensation cost for each tranche over the respective one-year requisite service period if it is probable that the target established for that year will be met.

• Total book compensation cost = $100,000

How many shares are included in diluted EPS for the year ended December 31, 20X6, assuming the shares are dilutive at the end of 20X6?

Using the treasury stock method, the diluted EPS computation would reflect the number of shares that would be issued based on the assumption that the current amount of revenue achieved will remain unchanged through the end of the performance period.

One way of viewing the contingent share guidance in ASC 260-10-45-48(b) in this case is to treat the amount of revenue generated in the current reporting period ($120 million) as if it were the amount earned in each respective contingent period, since each tranche is treated as a separate award. Under this approach, the 20X6 performance condition for revenue exceeding $100 million has been satisfied at the reporting date, and the 20X7 performance condition for revenue exceeding $115 million would have been satisfied if the reporting date was the end of that contingency period.

The performance conditions for 20X8 and 20X9 would not have been satisfied by revenue of $120 million. Therefore, under this approach, 5,000 shares (the 20X6 and 20X7 tranches) would be included in the diluted EPS computation process. The 20X8 and 20X9 tranches would not be included.

• Average unrecognized compensation cost for 20X6 = $37,500

Average of $50,000 (unrecognized compensation cost at January 1, 20X6 related to shares for which the performance condition has been or would have been satisfied based upon the current period results) and $25,000 (unrecognized compensation cost at December 31, 20X6 related to those same shares)

We believe an alternative approach would also be acceptable in this particular fact pattern in which the award includes multiple independent periods with discrete performance targets associated with service in that period. Under the alternative approach, the entity would not project any further earnings in future periods (as described in ASC 260-10-45-51 and footnote (f) of the example in ASC 260-10-55-56). Under this approach, only the 20X6 tranche of 2,500 shares would be included in the above calculations because as of the reporting date, no earnings would be assumed for the future independent periods. This approach may not be appropriate in fact patterns that vary from this illustration.

On January 1, 20X6, FSP Corp grants employees 10,000 shares of restricted stock. The shares are legally issued and outstanding, and the employee is not required to pay for the restricted stock.

The vesting provisions are market conditions that state that 50% of the restricted stock will vest if the stock price is higher than $18 on December 31, 20X9, and the remaining 50% of the restricted stock will vest if the stock price is higher than $22 on December 31, 20X9. The recipient is also required to still be employed at the vesting date; FSP Corp expects all of the employees to remain employed through that date. Any shares that do not vest will be forfeited. The fair value of the restricted stock on the grant date is $80,000; the effect of the market conditions is reflected (i.e., discounted) in the award’s fair value.

The market price of the underlying stock is $20 on December 31, 20X6, and the average stock price for the year ended December 31, 20X6 is $15 per share.

• Total book compensation cost = $80,000
• Compensation cost will be recognized ratably over four years ($20,000 per year)
• Unearned compensation cost at December 31, 20X6, is $60,000

How many shares are included in diluted EPS for the year ended December 31, 20X6, assuming the shares are dilutive at the end of 20X6?

Following the contingently issuable share guidance in ASC 260-10-45-48 and ASC 260-10-45-52, the diluted EPS computation should reflect the number of shares that would be issued based on comparing the stock price at the end of the period to the market condition metric. Because the stock price at the end of 20X6 is higher than the $18 threshold price but lower than the $22 threshold price, 50% of the restricted shares would be assumed to be issued.

• There are no cash proceeds for the restricted shares
• Average unrecognized compensation cost for 20X6 = $70,000

Although the stock price at the end of the period is only higher than the $18 threshold price and 50% of the shares would vest based upon that price, the entire award’s average unrecognized compensation cost is included in the treasury stock method proceeds calculation (not 50%). Under the stock compensation guidance, the effect of a market condition is reflected in the award’s fair value on the grant date and all compensation cost for an award that has a market condition should be recognized if the requisite service period is fulfilled, regardless of the level at which the market condition is satisfied (including even if the award never vests). This is because the likelihood of achieving the market condition is incorporated into the fair value of the award. Therefore, there is no direct correlation between the number of shares that ultimately vest in a market condition award and the amount of compensation cost recognized. As a result, changes in the number of shares assumed to be issued under the award for EPS purposes would not change the amount of compensation cost associated with the award that should be used in the treasury stock method calculations.

This differs from Example FSP 7-13 because, as noted above, an award with a market condition is accounted for and measured differently from an award that has a performance or service condition. For awards with performance or service conditions, there is a direct correlation between the number of shares that ultimately vest and the amount of compensation cost recognized; therefore, changes in the number of shares assumed to be issued under the award for EPS purposes would change the amount of compensation cost associated with the award that should be used in the treasury stock method calculations.

• Assumed repurchase = 4,666 shares

If the stock price were below $18 at the end of 20X6, which is less than the lowest threshold price, then none of the restricted shares would be included in the diluted EPS computation.

In computing diluted EPS, a reporting entity should treat the modification of a share-based award as if there was a cancellation and new issuance of an award. This includes modifications that are made in conjunction with an equity restructuring, such as a spin-off or large cash dividend.

Consistent with the approach described in ASC 260-10-45-26, the reporting entity should treat the “before” and “after” awards (i.e., the original and the modified awards) separately and include each for the weighted average period that each was outstanding.

• Based on the terms of the award and the average stock price for the period prior to the modification (weighted for the appropriate period)
• Based on the terms of the award and the average stock price for the period after the modification (weighted for the appropriate period)

The sum of the two calculations will equal the number of incremental shares to be included in the diluted EPS computation. The reporting entity does the “as if” cancellation and reissuance for any share-based payment award whose terms have changed.

Reporting entities that conclude that they should not account for the effects of a modification pursuant to ASC 718-20-35-2A through ASC 718-20-35-9 should still consider the changes it made to the award when applying ASC 260. For example, a reporting entity may modify an award by reducing both the strike price and the number of share options. If the value, the vesting conditions, and the classification of the award are the same immediately before and after the change to the award, then the reporting entity would not account for the effects of the modification. Although the reporting entity would not account for the effects of the modification, it should not ignore the changes it made to the award when it applies the guidance in ASC 260.

Under ASC 718, ESPPs are treated as options granted at the start of the offering period. Similarly, ESPPs are considered options to be included in diluted EPS using the treasury stock method because granting an employee the ability to purchase stock at a defined price through an ESPP is very similar to a conventional employee stock option with a vesting period. Both awards give the employee the ability to purchase reporting entity stock in the future at a potentially discounted price. Accordingly, an ESPP represents potential common shares that reporting entities should include in the denominator for the computation of diluted EPS. The same is true for non-compensatory ESPPs, except there would be no unrecognized compensation cost included in assumed proceeds under the treasury stock method.

Because the vesting of an ESPP is typically based on service, not performance, reporting entities should consider the plan in the denominator for diluted EPS purposes from the start date of the offering period. The fact that employees have amounts withheld from their paychecks to pay for the shares over time is a funding mechanism for the ultimate payment of the exercise price; it does not change the nature of the potentially dilutive option arrangement.

At the beginning of the ESPP offering period, management can begin to estimate how many shares of stock will eventually be purchased based on the employees’ withholding elections, the current stock price, and the terms of the ESPP (e.g., the purchase price discount), assuming that the employees continue their employment through the offering period. This is considered the grant date of the share-based compensation award under ASC 718-50-35-1. Changes to employee withholding elections are considered modifications for diluted EPS purposes and are reflected in diluted EPS on a prospective basis.

When including ESPPs in the computation of diluted EPS, a reporting entity must calculate the number of shares to be issued under the ESPP and the hypothetical number of shares that can be repurchased under the treasury stock method. The difference between these two amounts represents the incremental number of potential common shares to be included in the computation of diluted EPS, weighted for the appropriate period of time that the awards were outstanding during the reporting period.

After adoption of ASU 2020-06, we believe there are two acceptable methods to compute the number of shares issuable under the ESPP - either using the average market price during the period or following the contingently issuable shares guidance (which reflects historical practice prior to ASU 2020-06). The method elected should be consistently applied.

This view uses the average market price for the period to compute the number of shares to be issued under the ESPP. This view is based on the guidance in ASC 260-10-45-21A, which requires use of the average market price to calculate the denominator for diluted EPS when changes in an entity’s share price may affect the number of shares needed to settle the instrument. Since the calculation of the number of shares issuable upon completion of the offering period in most ESPPs is affected by the entity’s share price at that date, this guidance would apply and the average share price for the period would be used.

Under this approach, at each reporting date during the offering period, reporting entities would divide the total expected withholdings during the entire offering period (based on current employee elections) by the average market price during the reporting period applied to the purchase price formula (e.g., if the ESPP provides for a 15% discount from the stock price, then the average market price during the period should be multiplied by 85%) to calculate the number of shares issuable under the ESPP.

This view recognizes that prior to implementing ASU 2020-06, the number of shares issuable under an ESPP was determined by application of the contingently issuable shares guidance in ASC 260-10-45-48 through ASC 260-10-45-52. Under this view, the number of common shares issuable is calculated based on the number of shares that would be issuable if the reporting date were the end of the contingency period (applying the purchase price formula in the ESPP) because it is based on a future market price. Therefore, a reporting entity would utilize the entity’s share price as of the beginning of the offering period, the share price at the reporting date, and the purchase price formula defined in the ESPP to determine the number of shares issuable. This view reflects the language in the Basis for Conclusions of ASU 2020-06, which states “the Board decided to retain the current guidance for calculating diluted EPS for stock-based compensation because those arrangements are not within the scope of this project.”

Under this approach, the total expected withholdings during the entire offering period (based on current employee elections), the stock price at the beginning of the offering period and at the reporting date, and the purchase price formula for the ESPP determine the number of shares considered issuable under the plan, consistent with ASC 260-10-45-52 for market price contingencies. Therefore, if the plan requires the purchase price to be 85% of the lesser of the beginning or ending stock price in the offering period, the reporting entity would compare the stock price at the beginning of the offering period to the stock price at the reporting date and use the lower of those two stock prices (multiplied by 85%) in the calculation of the number of shares issuable under the ESPP. If the formula uses an average stock price over a period of time (such as the last 10 business days before the purchase date), the average for that same period of time as of the end of the reporting period should be used, consistent with ASC 260-10-45-52.

Under either approach, the hypothetical number of shares that could be repurchased (using the average market price for the period) is netted against the number of shares issuable under the ESPP in order to determine the incremental shares to be included in the calculation of diluted EPS under the treasury stock method. The reporting entity should determine the assumed proceeds to be used in this calculation as the sum of (1) the cash assumed to be received over the course of the offering period (based on current employee elections), and (2) the average unrecognized compensation cost related to the ESPP during the period.

The reporting entity would then divide the total assumed proceeds by the average stock price for the reporting period to determine the hypothetical number of shares that can be repurchased. In calculating the dilutive effect of an ESPP on EPS, reporting entities should incorporate the aggregate expected amount of withholdings during the entire offering period, rather than only the withholding amount received up to the reporting date. Reporting entities should consider the entire offering period because the ESPP is treated as an option for both accounting and EPS purposes. Accordingly, reporting entities should consider all amounts to be withheld from employees to purchase shares under the plan, both current withholdings and expected withholdings, as part of the assumed proceeds under the treasury stock method for EPS. Furthermore, because the amount withheld from employees is recorded by the reporting entity as a liability (as it belongs to the employees until the offering period has ended), it is not considered a prepayment of the purchase price of the shares for diluted EPS purposes and, therefore, continues to be included in the assumed proceeds for the treasury stock method calculation.

• assess employment status and employee participation as of the reporting date to ensure that employees’ elections are appropriately considered in the computation,
• determine the exercise (i.e., purchase) price by utilizing either (a) the average stock price during the reporting period and the purchase price discount defined in the ESPP (if applying the approach in ASC 260-10-45-21A) or (b) the stock price as of the beginning of the offering period, the stock price at the reporting date, and the purchase price formula defined in the ESPP (if applying the contingently issuable shares guidance consistent with historical practice),
• project total withholdings over the course of the offering period, and
• calculate the number of shares issuable under the ESPP and hypothetical repurchases under the treasury stock method (considering total expected withholdings and average unrecognized compensation cost as assumed proceeds). The difference between these two amounts represents the net incremental number of potential common shares to be included in the diluted EPS calculation, weighted for the portion of the reporting period that the ESPP offering period was outstanding

Example FSP 7-15 illustrates the computation of diluted EPS for an ESPP after adoption of ASU 2020-06. This example depicts the calculation of the number of shares issuable under the ESPP using both the average market price during the period and the contingently issuable shares guidance.

FSP Corp has an ESPP that begins a six-month offering period on October 1, 20X6 (ending on March31, 20X7).

The ESPP allows employees to elect to withhold a certain amount of their salary (up to 15%) to purchase the reporting entity’s stock at a discounted price.

The ESPP provides for shares to be purchased at 85% of the lesser of the stock price at the beginning or end of the offering period (i.e., a look-back option) and is considered compensatory. Since the plan is compensatory, the reporting entity recognizes compensation cost for the ESPP.

Employees are allowed to withdraw from the ESPP at any time during the offering period, are required to withdraw if terminated, and upon withdrawal will be reimbursed any amount withheld.

The stock price on October 1, 20X6, the beginning of the six-month offering period, is $25. After applying the ESPP’s discount, the formula price would be $21.25 ($25 × 85%).

The stock price on December 31, 20X6, the reporting date, is $20. After applying the ESPP’s discount, the formula price (if determined at this date) would be $17 ($20 × 85%).

Employee withholdings at December 31, 20X6 total $3,380,000. Expected withholdings for the remaining offering period, based on current employee elections, is $3,420,000. Therefore, the expected total withholdings are $6,800,000.

Average unrecognized compensation cost during the period from October 1 to December 31, 20X6 is $1,000,000.

How many shares should FSP Corp include in diluted EPS for the year ended December 31, 20X6, assuming the shares are dilutive at the end of 20X6?

In applying the average market price guidance in ASC 260-10-45-21A, FSP Corp would calculate the number of shares projected to be issued under the ESPP as of December 31, 20X6 as 363,636, determined as follows:

$6,800,000 (expected total withholding amount) divided by $18.70 (average stock price for the period of $22 multiplied by ESPP formula of 85% of stock price)

$6,800,000 (expected total withholding amount) plus $1,000,000 (average unrecognized compensation cost during the reporting period)

Incremental shares to be included in the December 31, 20X6 diluted EPS computation = 2,273 shares, calculated as follows:

[363,636 (gross number of shares to be issued under the ESPP) minus 354,545 (shares assumed repurchased)] x 3 / 12 (ESPP is outstanding for 3 of 12 months in 20X6)

Alternatively, if FSP Corp applied the contingently issuable share guidance (consistent with historical practice prior to adoption of ASU 2020-06) in calculating diluted EPS for its ESPP, the number of shares projected to be issued would be 400,000, and the resulting incremental shares to be included in the December 31, 20X6 diluted EPS computation would be 11,364. The shares assumed to be repurchased under the treasury stock method is unchanged as assumed proceeds are divided by the average stock price under both methods. See below for detailed calculations.

$6,800,000 (expected total withholding amount) divided by $17 (purchase price per share determined by the ESPP purchase price formula based on the December 31, 20X6 stock price)

The formula price of $17 per share on the reporting date is used because the ESPP contains a look-back option and this price is lower than the formula price at the beginning of the offering period. If the stock price on the reporting date was greater than the stock price at the beginning of the offering period, the reporting entity would use the formula price at the beginning of the offering period to calculate the shares projected to be issued due to the look-back option.

Incremental shares to be included in the December 31, 20X6 diluted EPS computation = 11,364, determined as follows:

[400,000 (gross number of shares to issue under the ESPP as calculated above) minus 354,545 (shares assumed repurchased)] x 3 / 12 (ESPP is outstanding for 3 of 12 months in 20X6)

Under ASC 718, ESPPs are treated as options which are granted at the start of the offering period. Similarly, ESPPs are considered options to be included in diluted EPS using the treasury stock method because granting an employee the ability to purchase stock at a defined price through an ESPP is very similar to a conventional employee stock option with a vesting period. Both awards give the employee the ability to purchase reporting entity stock in the future at a potentially discounted price. Accordingly, an ESPP represents potential common shares that reporting entities should include in the denominator for the computation of diluted EPS. The same is true for non-compensatory ESPPs, except there would be no unrecognized compensation cost included in assumed proceeds under the treasury stock method.

Because the vesting of an ESPP is typically based on service, not performance, reporting entities should consider the plan in the denominator for diluted EPS purposes from the start date of the offering period. The fact that employees have amounts withheld from their paychecks to pay for the shares over time is a funding mechanism for the ultimate payment of the exercise price; it does not change the nature of the potentially dilutive option arrangement.

At each reporting date during the offering period, reporting entities should apply the guidance in ASC 260-10-45-48 through ASC 260-10-45-52 for contingently issuable shares, and ASC 260-10-45-22 through ASC 260-10-45-26 for the treasury stock method. Under this guidance, the number of incremental potential common shares included in diluted EPS is based on the number of shares that would be issuable if the reporting date were the end of the contingency period, net of the hypothetical shares that could be repurchased under the treasury stock method.

The employees’ withholding elections at period-end, the stock price at the beginning of the offering period and at the reporting date, and the purchase price formula for the ESPP will determine the number of shares issuable under the plan, consistent with ASC 260-10-45-52, for market price contingencies. Therefore, if the plan requires the purchase price to be the lesser of the beginning or ending stock price in the offering period, the reporting entity would compare the stock price at the beginning of the offering period to the stock price at the reporting date and use the lower of those two stock prices in the calculation of purchase price.

The reporting entity should calculate the assumed proceeds under the treasury stock method based on the sum of (1) the cash assumed to be received over the course of the offering period, and (2) the average unrecognized compensation cost related to the ESPP during the period.

The reporting entity would divide the total assumed proceeds by the average stock price for the reporting period to determine the hypothetical number of shares that can be repurchased under the treasury stock method.

In calculating the dilutive effect of an ESPP on EPS, reporting entities should base the number of shares issued on the aggregate expected amount of withholdings during the entire offering period, rather than only the withholding amount received up to the reporting date. Reporting entities should consider the entire offering period because the ESPP is treated as an option for both accounting and EPS purposes. Accordingly, reporting entities should consider all amounts to be withheld from employees to purchase shares under the plan, both current withholdings and expected withholdings, as part of the assumed proceeds under the treasury stock method for EPS.

Because the amount withheld from employees is recorded by the reporting entity as a liability (as it belongs to the employees until the offering period has ended), it is not considered a prepayment of the purchase price of the shares for diluted EPS purposes and therefore, continues to be included in the assumed proceeds for the treasury stock method calculation.

At the beginning of the ESPP offering period, management can determine, based on the employees’ withholding elections and the current stock price, how many shares of stock will eventually be purchased, assuming that the employees continue their employment through the offering period. This is considered the grant date of the share-based compensation award under ASC 718-50-35-1. Changes to employee withholding elections are considered modifications for diluted EPS purposes and are reflected in diluted EPS on a prospective basis.

• assess employment status and employee participation as of the reporting date to ensure that employees’ elections are appropriately considered in the computation,
• determine the exercise price by utilizing the stock price as of the beginning of the offering period, the stock price at the reporting date, and the purchase price formula defined in the ESPP,
• project total withholdings over the course of the offering period, and
• calculate the number of shares to be issued under the ESPP and hypothetical repurchases under the treasury stock method (considering total expected withholdings and average unrecognized compensation cost as assumed proceeds). The difference between these two amounts represents the net incremental number of potential common shares to be included in the diluted EPS calculation.

Example FSP 7-16A illustrates the computation of diluted EPS for an ESPP before adoption of ASU 2020-06.

EXAMPLE FSP 7-16A
Impact on diluted EPS of an employee stock purchase plan - before adoption of ASU 2020-06

FSP Corp has an ESPP that begins a six-month offering period on September 1, 20X6 (ending on February 28, 20X7).

The ESPP allows employees to elect to withhold a certain amount of their salary (up to 15%) to purchase the reporting entity’s stock at a discounted price.

The ESPP provides for shares to be purchased at 85% of the lesser of the stock price at the beginning or end of the offering period (i.e., a look-back option) and is considered compensatory. Since the plan is compensatory, the reporting entity recognizes compensation cost for the ESPP.

Employees are allowed to withdraw from the ESPP at any time during the offering period, are required to withdraw if terminated, and upon withdrawal will be reimbursed any amount withheld.

The stock price on September 1, 20X6, the beginning of the six-month offering period, is $25. After applying the ESPP’s discount, the formula price would be $21.25 ($25 × 85% = $21.25).

The stock price on December 31, 20X6, the reporting date, is $20. After applying the ESPP’s discount, the formula price would be $17 ($20 × 85% = $17).

Employee withholdings at December 31, 20X6, total $4,500,000. Expected withholdings for the remaining offering period, based on current employee elections, is $2,300,000. Therefore, the expected total withholdings are $6,800,000.

Average unrecognized compensation cost during the period from September 1 to December 31, 20X6 = $1,650,000.

How many shares should FSP Corp include in diluted EPS for the year ended December 31, 20X6, assuming the shares are dilutive at the end of 20X6?

FSP Corp would calculate the number of shares projected to be issued at December 31, 20X6 under the ESPP as 400,000, determined as follows:

$6,800,000 (expected total withholding amount) divided by $17 (purchase price per share determined by the ESPP purchase price formula)

The formula price of $17 per share on the reporting date is used because the ESPP contains a look-back option and this price is lower than the formula price at the beginning of the offering period. If the stock price on the reporting date was greater than the stock price at the beginning of the offering period, the reporting entity would have used the formula price at the beginning of the offering period to calculate the shares projected to be issued due to the look-back option.

$6,800,000 (expected total withholding amount) plus $1,650,000 (average unrecognized compensation cost during the reporting period)

Incremental shares to be included in the December 31, 20X6 diluted EPS computation = 5,303 shares, calculated as follows:

[400,000 (gross number of shares to issue under the ESPP) minus 384,091 shares (assumed repurchased)] x 4 / 12 (ESPP is outstanding for 4 of 12 months in 20X6)

Because most ESPPs provide for the purchase of shares at a discount to the market price, there is typically a dilutive effect on EPS. However, the inclusion of unrecognized compensation cost in the calculation of assumed proceeds tends to mitigate the impact, particularly in the earlier portions of the offering period. Once there is an obligation to issue shares (on March 1 in the above example), the shares would be included in basic EPS on a prospective basis. During the quarter ending March 31, along with being included in basic EPS for the one month from March 1 to March 31, the ESPP would also affect diluted EPS on a weighted average basis for the period from January 1 to February 28.

A stock-appreciation right (SAR) is a contract that gives the employee the right to receive an amount of stock that equals the appreciation in a company’s stock from an award’s grant date to the exercise date. SARs generally do not involve payment of an exercise price and may be settled in cash or in stock.

If a SAR is required to be settled in cash, the only effect the cash-settled SAR would have on the numerator is through the recognition of compensation cost in net income.

If a SAR is required to be settled in stock, it will be included in the computation of diluted EPS (if the award is dilutive) based on the net number of shares issuable using the average stock price for the period. Because an employee typically does not pay to exercise a stock-settled SAR, only unrecognized compensation cost is considered proceeds when calculating the dilutive effect under the treasury stock method.

If the reporting entity or the employee can decide whether a SAR will be settled in cash or in stock, see FSP 7.5.7.1 (after adoption of ASU 2020-06) or FSP 7.5.7.1A (before adoption of ASU 2020-06) for the appropriate EPS treatment.

Some cash and stock-settled SARs may be treated differently for determining the classification of an award and related compensation cost to be recorded, and for EPS purposes. For example, a SAR that provides the employee with the choice of settlement method is a liability-classified award; however, EPS will be computed on the assumption that the award will be settled in shares because it is more dilutive. In accordance with ASC 260-10-55-33, the reporting entity should not adjust the numerator for recorded compensation expense in that situation.

7.5.5.6 Market prices used in the treasury stock method

In applying the treasury stock method, a simple average of market prices usually will be adequate. As noted in ASC 260-10-55-5, closing daily market prices are generally adequate for use in computing the average market price. When prices fluctuate widely, however, an average of the daily high and low price usually would be more representative. A reporting entity should consistently apply the method used to compute the average market price unless it is no longer representative because of changed conditions.

When market prices are unavailable (e.g., the pre-IPO period for a reporting entity going public, or a reporting entity that has been delisted) for periods presented in the financial statements, management should use its best estimate of the fair value of the entity’s shares during the period. Management’s determination of fair value of its shares should be consistent with the fair values and assumptions used in the calculation of the reporting entity’s stock compensation cost and disclosures.

7.5.5.7 Year-to-date computations pursuant to the treasury stock method

Earnings per share for a quarter should be based on the weighted average number of shares of common stock and dilutive potential common shares outstanding during that quarter, rather than calculated as the difference between year-to-date earnings per share and cumulative earnings per share for previous quarters of the fiscal year. When performing year-to-date computations pursuant to the treasury stock method, the reporting entity does not perform the year-to-date computation independently using the whole year as the averaging period; rather, it is an average of the quarters’ weighted average incremental shares under the treasury stock method. For the purpose of determining the weighted average number of shares in applying the treasury stock method to year-to-date computations, reporting entities should use the guidance in ASC 260-10-55-3.

Excerpt from ASC 260-10-55-3

…the number of incremental shares to be included in the denominator shall be determined by computing a year-to-date weighted average of the number of incremental shares included in each quarterly diluted EPS computation.

However, in computing year-to-date diluted EPS, reporting entities should use year-to-date income (or loss) from continuing operations as the basis for determining whether or not dilutive potential common shares not included (or included) in one or more quarterly computations of diluted EPS are included in the year-to-date computation.

For example, if a reporting entity had a year-to-date loss from continuing operations that included quarters with income, any incremental shares included in the quarters with income would not be included in the denominator for the year-to-date diluted EPS computation. Likewise, if a reporting entity had year-to-date income, and in-the-money options or warrants were excluded from one or more quarterly diluted EPS computations because the effect was anti-dilutive due to a loss in that quarter, then those options or warrants should be included in the EPS denominator (on a weighted average basis) in the year-to-date computation.

Disclosure in the annual report of the quarterly per share data required by Regulation S-K 302 should reflect the average shares outstanding during each particular quarter. If the sum of such quarterly EPS amounts differs significantly from annual EPS, the reason for the difference should be explained in a note to the quarterly financial data included in the annual report.

See ASC 260-10-55-3A, Example 1 in ASC 260-10-55-38 through ASC 260-10-55-50, and Example 12 in ASC 260-10-55-85 for an illustration of this concept.

7.5.5.8 Modifications to use of the treasury stock method

Options or warrants may permit or require the holder of the option to tender debt or other securities of the issuer (or its subsidiary or parent) in payment of all or a portion of the exercise price.

In computing diluted EPS, the reporting entity assumes (1) those options or warrants are exercised, and (2) the debt or other securities is tendered (this is, effectively, the if-converted method which is discussed in FSP 7.5.6 (after adoption of ASU 2020-06) and FSP 7.5.6A (before adoption of ASU 2020-06)). The reporting entity adds back interest (net of tax) on any debt assumed to be tendered to the numerator and also adjusts the numerator for any nondiscretionary adjustments based on income (net of tax), such as profit-sharing and royalty agreements. See ASC 260-10-55-9.

If tendering cash, however, would be more advantageous to the option or warrant holder, and the contract permits tendering cash, the reporting entity should apply the treasury stock method. See ASC 260-10-55-9.

The terms of certain options or warrants may require that proceeds received from their exercise be applied to retire debt or other securities of the issuer (or its parent or subsidiary). In computing diluted EPS, the reporting entity assumes those options or warrants are exercised and the proceeds applied to purchase the debt at its average market price rather than to purchase common stock under the treasury stock method. In doing so, it should add back interest (net of tax) on any debt assumed to be repurchased to income available to common stockholders. It also adjusts the numerator for any nondiscretionary adjustments based on income (net of tax). However, the reporting entity should apply the treasury stock method for excess proceeds received from the assumed exercise (i.e., the proceeds received on exercise exceed the amount of debt retired). See ASC 260-10-55-10.

Convertible securities that permit or require the payment of cash by their holder at conversion are deemed to be warrants. In computing diluted EPS, the reporting entity should apply the proceeds assumed to be received to purchase common stock using the treasury stock method and should assume the convertible security is converted under the if-converted method. See ASC 260-10-55-11.

7.5.5.9 Reverse treasury stock method — after adoption of ASU 2020-06

Contracts that require the reporting entity to repurchase its own stock (such as written put options and forward purchase contracts, other than physically-settled forward purchase contracts for a fixed number of shares accounted for pursuant to ASC 480-10-45-4; see FSP 7.4.3.6) are reflected in the computation of diluted EPS if their effect is dilutive.

A reporting entity should not deduct the shares underlying a forward repurchase contract that allows or requires net cash or net share settlement from weighted average common shares outstanding for purposes of calculating basic and diluted earnings per share. That treatment is only applicable to forward contracts that require the delivery of a fixed number of shares for a fixed amount of cash at settlement.

A forward repurchase contract that requires net cash settlement should not be included in the denominator of the computation of diluted earnings per share because the contract does not allow for share settlement, nor should there be an adjustment to the numerator for the gain or loss recorded through earnings for the period. A forward repurchase contract that allows for net share settlement or gross physical settlement, or physical settlement in exchange for specified quantities of assets other than cash, should be included in the computation of diluted earnings per share using the reverse treasury stock method described in ASC 260-10-45-35. A forward repurchase contract that allows for net cash or net share settlement (or net cash or physical settlement) should be included in the computation of diluted earnings per share using the reverse treasury stock method and share settlement must be assumed in accordance with ASC 260-10-45-45. In performing the reverse treasury stock method for these contracts, the gain or loss on the contract that was recorded through earnings for the period should be added to or deducted from the numerator. These contracts may be anti-dilutive and, in such cases, there would be no adjustment to earnings per share.

1. Issuance of sufficient common shares shall be assumed at the beginning of the period (at the average market price during the period) to raise enough proceeds to satisfy the contract.
2. The proceeds from issuance shall be assumed to be used to satisfy the contract (that is, to buy back shares).
3. The incremental shares (the difference between the number of shares assumed issued and the number of shares received from satisfying the contract) shall be included in the denominator of the diluted EPS computation.

The effect of potential share settlement shall be included in the diluted EPS calculation (if the effect is more dilutive) for an otherwise cash settleable 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 the entity has a history or policy of cash settlement). An example of such a contract accounted for in accordance with this paragraph and paragraph 260-10-45-46 is a written call option that gives the holder a choice of settling in common stock or in cash. An election to share settle an instrument, for purposes of applying the guidance in this paragraph, does not include circumstances in which share settlement is contingent upon the occurrence of a specified event or circumstance (such as contingently issuable shares). In those circumstances (other than if the contingency is an entity’s own share price), the guidance on contingently issuable shares should first be applied, and, if the contingency would be considered met, then the guidance in this paragraph should be applied. Share-based payment arrangements that are payable in common stock or in cash at the election of either the entity or the grantee shall be accounted for pursuant to this paragraph and paragraph 260-10-45-46, unless the share-based payment arrangement is classified as a liability because of the requirements in paragraph 718-10-25-15 (see paragraph 260-10-45-45A for guidance for those instruments). If the payment of cash is required only upon the final liquidation of an entity, then the entity shall include the effect of potential share settlement in the diluted EPS calculation until the liquidation occurs.

A written put option that is required to be net cash settled should not be included in the denominator of the diluted earnings per share computation because it does not allow for share settlement, nor should there be an adjustment to the numerator for the gain or loss recorded through earnings for the period. A written put option that is required to be settled in shares should be included in the computation of diluted earnings per share using the reverse treasury stock method as described in ASC 260-10-45-35. A written put option that allows for net share or net cash settlement should also be included in the computation of diluted earnings per share using the reverse treasury stock method and share settlement must be assumed as discussed in ASC 260-10-45-45. In performing the reverse treasury stock method for these contracts, the gain or loss on the contract that was recorded through earnings for the period should be added to or deducted from the numerator. These contracts may be anti-dilutive and, in such cases, there would be no adjustment to earnings per share.

The exercise price of a written put option on an entity’s own stock can be prepaid at inception. In these cases, the issuing entity pays the exercise price of the put option at issuance (net of the related option premium).

If the put option expires out of the money, the issuing entity typically receives its prepayment back, as the written put option will not be exercised. If the put option is in the money, the counterparty will typically exercise its put right, and the issuing entity will receive the shares underlying the contract. In either case, there is no impact on the calculation of diluted EPS.

If the written put option expires unexercised, the number of common shares outstanding is unaffected. If the put option is exercised, there is no payment of the exercise price required; therefore, use of the reverse treasury stock method would yield an anti-dilutive result (as there is no need to issue a sufficient number of shares to satisfy the exercise price.

Example FSP 7-17 illustrates the application of the reverse treasury stock method to written put options.

FSP Corp sells a put option that allows the investor to sell 100 shares to FSP Corp at an exercise price of $25; the average market price for the period is $20.

• Assume 125 shares are issued at the beginning of the period to raise enough proceeds to satisfy the put option exercise price of $2,500 (100 shares at $25). Number of shares assumed to have been issued is calculated by dividing the required proceeds of $2,500 by the average market price of $20 per share for the period.
• The $2,500 in proceeds from issuance of new shares is then used to satisfy the put on 100 shares.
• The EPS computation should include 25 incremental shares—125 shares assumed to be issued less the 100 shares assumed to have been repurchased.

7.5.5.9A Reverse treasury stock method—before adoption of ASU 2020-06

Contracts that require the reporting entity to repurchase its own stock (such as written put options and forward purchase contracts, other than physically-settled forward purchase contracts for a fixed number of shares accounted for pursuant to ASC 480-10-45-4; see FSP 7.4.3.6) are reflected in the computation of diluted EPS if their effect is dilutive.

A reporting entity should not deduct the shares underlying a forward repurchase contract that allows or requires net cash or net share settlement from weighted average common shares outstanding for purposes of computing basic and diluted earnings per share. That treatment is only applicable to forward contracts that require the delivery of a fixed number of shares for a fixed amount of cash at settlement.

A forward repurchase contract that requires net cash settlement should not be included in the denominator of the diluted earnings per share computation because the contract does not allow for share settlement, nor should there be an adjustment to the numerator for the gain or loss recorded through earnings for the period. A forward repurchase contract that allows for net share settlement or gross physical settlement should be included in the computation of diluted earnings per share using the reverse treasury stock method described in ASC 260-10-45-35. A forward repurchase contract that allows for either net cash or net share settlement should be included in the computation of diluted earnings per share using the reverse treasury stock method and the guidance applicable to contracts that may be settled in cash or shares (see FSP 7.5.7.1A). In performing the reverse treasury stock method for these contracts, the gain or loss on the contract that was recorded through earnings for the period should be added to or deducted from the numerator. These contracts may be anti-dilutive and, in such cases, there would be no adjustment to earnings per share.

1. Issuance of sufficient common shares shall be assumed at the beginning of the period (at the average market price during the period) to raise enough proceeds to satisfy the contract.
2. The proceeds from issuance shall be assumed to be used to satisfy the contract (that is, to buy back shares).

The incremental shares (the difference between the number of shares assumed issued and the number of shares received from satisfying the contract) shall be included in the denominator of the diluted EPS computation.

A written put option that is required to be net cash settled should not be included in the denominator of the diluted earnings per share computation because it does not allow for share settlement, nor should there be an adjustment to the numerator for the gain or loss recorded through earnings for the period. A written put option that is required to be settled in shares should be included in the computation of diluted earnings per share using the reverse treasury stock method described in ASC 260-10-45-35. A written put option that allows for net share or net cash settlement should also be included in the computation of diluted earnings per share using the reverse treasury stock method and the guidance applicable to contracts that may be settled in cash or shares (see FSP 7.5.7.1A). In performing the reverse treasury stock method for these contracts, the gain or loss on the contract that was recorded through earnings for the period should be added to or deducted from the numerator. These contracts may be anti-dilutive and, in such cases, there would be no adjustment to earnings per share.

The exercise price of a written put option on an entity’s own stock can be prepaid at inception. In these cases, the issuing entity pays the exercise price of the put option at issuance (net of the related option premium).

If the put option expires out of the money, the issuing entity typically receives its prepayment back, as the written put option will not be exercised. If the put option is in the money, the counterparty will typically exercise its put right, and the issuing entity will receive the shares underlying the contract. In either case, there is no impact on the calculation of diluted EPS.

If the written put option expires unexercised, the number of common shares outstanding is unaffected. If the put option is exercised, there is no payment of the exercise price required; therefore, use of the reverse treasury stock method would yield an anti-dilutive result (as there is no need to issue a sufficient number of shares to satisfy the exercise price.

Example FSP 7-17A illustrates the application of the reverse treasury stock method to written put options before adoption of ASU 2020-06.

FSP Corp sells a put option that allows the investor to sell 100 shares to FSP Corp at an exercise price of $25; the average market price for the period is $20.

• Assume 125 shares are issued at the beginning of the period to raise enough proceeds to satisfy the put option exercise price of $2,500 (100 shares at $25). Number of shares assumed to have been issued is calculated by dividing the required proceeds of $2,500 by the average market price of $20 per share for the period.
• The $2,500 in proceeds from issuance of new shares is then used to satisfy the put on 100 shares.
• The EPS computation should include 25 incremental shares—125 shares assumed to be issued less the 100 shares assumed to have been repurchased.

7.5.6 If-converted method for convertible securities—after adoption of ASU 2020-06

ASC 260 considers all convertible securities, including convertible debt and convertible preferred stock, which by their terms may be converted into common stock of the reporting entity, as potential common shares.

Share-settled convertible debt and convertible preferred stock are generally included in diluted EPS using the if-converted method as described in ASC 260-10-45-40 through ASC 260-10-45-42.

Definition from ASC 260-10-20

If-converted method: A method of computing EPS data that assumes conversion of convertible securities at the beginning of the reporting period (or at time of issuance, if later).

The dilutive effect of convertible securities should be reflected in diluted EPS by application of the if-converted method as described in ASC 260-10-45-40.

The dilutive effect of convertible securities shall be reflected in diluted EPS by application of the if-converted method. Under that method:

1. If an entity has convertible preferred stock outstanding, the preferred dividends applicable to convertible preferred stock shall be added back to the numerator. The amount of preferred dividends added back will be the amount of preferred dividends for convertible preferred stock deducted from income from continuing operations (and from net income) in computing income available to common stockholders pursuant to paragraph 260-10-45-11.
2. If an entity has convertible debt outstanding:
   1. Interest charges applicable to the convertible debt shall be added back to the numerator. For convertible debt for which the principal is required to be paid in cash, the interest charges shall not be added back to the numerator.
   2. To the extent nondiscretionary adjustments based on income made during the period would have been computed differently had the interest on convertible debt never been recognized, the numerator shall be appropriately adjusted. Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.
   3. The numerator shall be adjusted for the income tax effect of (b)(1) and (b)(2).

   When applying the if-converted method to convertible preferred stock, a reporting entity adds back the preferred dividends (declared or cumulative undeclared) applicable to the convertible preferred stock in the period to the diluted EPS numerator. Such add-back would also include any adjustments charged or credited to equity in the period to accrete preferred stock classified as mezzanine equity to its cash redemption price (or recorded upon a redemption or induced conversion), and any participating dividends allocated to the convertible preferred stock in the period for purposes of basic EPS.

   A reporting entity with convertible debt outstanding will adjust the numerator for the income tax effect of interest charges and nondiscretionary adjustments, computed on a “with or without” basis. Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit sharing and royalty agreements.

   The if-converted calculations are not affected by the reporting entity’s current stock price in relation to the conversion price. That is, a convertible security has the same effect on diluted EPS when the conversion option is far out of the money (i.e., the security has little chance of being converted), as it does when it is deep in the money (i.e., the security has a high likelihood of being converted).

   In determining the common shares to be included in the denominator under the if-converted method, if the number of shares issuable upon conversion is variable, reporting entities should follow the guidance in ASC 260-10-45-21A, which requires the use of the average market price when determining the number of shares that may be issued.

   Convertible debt in which the principal amount must be settled in cash and the “conversion spread value” in shares (known in practice as an “Instrument C” bond) is included in diluted EPS using the if-converted method as described in ASC 260-10-55-84 through ASC 260-10-55-84B. Specifically, there would be no interest expense adjustment to the numerator for the cash-settled portion of the instrument because that portion will always be settled in cash (see ASC 260-10-45-40). Similarly, for convertible preferred stock for which the stated value is required to be paid in cash, a reporting entity should not add the preferred dividends back to the diluted EPS numerator in applying the if-converted method (by analogy to the convertible debt guidance in ASC 260-10-45-40(b)(1)).

   The denominator of diluted EPS for Instrument C is determined by dividing the “conversion spread value” of the share-settled portion of the instrument by the average share price over the reporting period. The “conversion spread value” is the value that would be delivered to investors in shares based on the terms of the bond upon an assumed conversion. In addition, for the purpose of determining the weighted average number of shares for the year-to-date diluted EPS computation for Instrument C, the number of incremental shares to be included in the denominator should be determined by averaging the number of incremental shares included in each quarterly diluted EPS computation.

   The issuer of a debt instrument that may settle the bond upon conversion in any combination of cash or shares at the issuer’s option (known in practice as an “Instrument X” bond) must assume for purposes of the diluted EPS computation that the instrument is settled in shares. See FSP 7.5.7.1 for details.

   When the conversion feature embedded in a convertible debt instrument is bifurcated from the debt host and accounted for separately pursuant to the derivative accounting literature, the debt host and the separated conversion feature (i.e., the embedded derivative) are each treated as a separate unit of account. The discount created on the debt by separation of the conversion feature should be amortized through interest expense over the life of the debt, and the conversion feature should be measured at fair value each reporting period with changes in fair value included in earnings.

   Despite the fact that the debt and conversion feature are considered separate units of account for accounting purposes, they are treated as one instrument for EPS purposes (as it is a single convertible debt instrument) and included in the diluted EPS calculation using the if-converted method.

   In addition to the adjustment for interest expense (which includes amortization of the discount created upon bifurcation of the conversion option from the debt), the change in fair value each period related to the bifurcated conversion option should be deducted from/added back to the numerator (adjusted for any tax effect) in calculating diluted EPS.

   As discussed further in FSP 7.5.7.1, ASC 260-10-55-32 requires reporting entities to exclude the income statement impact of instruments assumed to be settled in shares for EPS purposes and that are required to be reported as assets or liabilities, from the numerator in the diluted EPS calculation. The fair value adjustment is nondiscretionary in all periods, whether a gain or loss, and so should be deducted from/added to the numerator. As a result of the adjustments to the diluted EPS numerator for the interest expense and fair value gain or loss, and the denominator adjustment for the number of shares assumed to be converted, the security may be dilutive or anti-dilutive. If anti-dilutive, the security should be excluded from the diluted EPS calculation altogether.

   If a reporting entity enters into an interest rate swap as a hedge of the interest associated with convertible debt that automatically terminates upon settlement or conversion of the debt (i.e., termination is nondiscretionary), the interest expense adjustment to the numerator is inclusive of the impact on interest expense arising from interest rate swaps formally designated as hedging instruments. If the swap arrangement does not automatically terminate upon conversion, the reporting entity should exclude the impact of the swap from the add-back and add back only the contractual interest on the debt in the numerator.

   Conversion is not assumed for purposes of computing diluted EPS if the effect would be anti-dilutive, such as in the following situations:

   • Convertible debt is anti-dilutive when its interest and nondiscretionary adjustments (net of tax) per common share obtainable on conversion exceeds basic EPS.
   • Convertible preferred stock is anti-dilutive when the amount of the dividend declared in, or accumulated for, the current period, including any deemed dividends or related accretion and participation in dividends, per common share obtainable on conversion exceeds basic EPS.

   Similarly, in periods of net loss, the application of the if-converted method to convertible securities is generally anti-dilutive (see FSP 7.5.7.1 for a situation when it may not be).

   Reporting entities should include convertible securities that have a dilutive effect on EPS in the denominator of diluted EPS from the beginning of the period or from the date of issuance, if later. They should also include dilutive convertible securities that are extinguished or redeemed, and securities in which the conversion options lapsed, in the denominator for the period they were outstanding. Consistent with ASC 260-10-S99-2, in circumstances when dilutive convertible securities are extinguished or redeemed and there is a gain or loss on extinguishment or induced conversion reflected in the numerator of basic EPS, the gain or loss should be reversed in the numerator of diluted EPS because the shares are assumed to have been converted at the beginning of the period.

   Dilutive convertible securities converted during the period are included in the denominator of diluted EPS for the period prior to their conversion. Thereafter, the shares issued are included in the denominator of both basic and diluted EPS.

   Example FSP 7-18 and Example FSP 7-19 illustrate the application of the if-converted method for convertible debt.

   EXAMPLE FSP 7-18
   Application of the if-converted method to convertible debt

   On January 1, 20X7, FSP Corp issued $10 million of convertible bonds (10,000 bonds in $1,000 increments), at par. On the issuance date, FSP Corp’s common stock price was $100 per share. The terms of the bonds include:

   • A coupon rate of 2% per year, which results in after-tax interest expense of $30,000 per quarter ($10 million x 2% x 1/4 = $50,000 less income tax of $20,000 (40% tax rate x $50,000)).
   • A requirement that FSP Corp deliver 8 shares per bond to bondholders upon conversion (which equates to a conversion price of $125), or 80,000 shares (10,000 bonds x 8 shares per bond) in total.

   FSP Corp has 10 million weighted average common shares outstanding, and net income for the quarter ended March 31, 20X7 is $50 million.

   How should FSP Corp include the convertible bonds in the diluted EPS computation for the period ended March 31, 20X7?

   Analysis

   FSP Corp should include the convertible bonds in diluted EPS using the if-converted method as follows.

   Adjustments Diluted EPS Weighted average common shares and potential common shares

   EXAMPLE FSP 7-19
   Computing year-to-date diluted EPS when convertible debt is anti-dilutive in certain periods and dilutive in others

   FSP Corp is profitable for the year but has net losses in the first and second quarters of 20X7. FSP Corp issued convertible debt in the prior year, which has been outstanding for all of 20X7.

   When adding back interest expense on the convertible debt and adjusting the weighted average shares to reflect conversion at the beginning of those periods, the results are anti-dilutive for both the discrete quarters and for the year-to-date EPS computation for the first and second quarters. The result of assuming conversion in the third and fourth quarters is dilutive.

   How would FSP Corp compute year-to-date EPS for the third and fourth quarters of 20X7? Analysis

   For the nine- and twelve-month period computations, the assessment of whether the convertible debt is anti-dilutive should consider the entire period for which the convertible debt was outstanding (the nine- or twelve-month periods). The fact that there are discrete quarters in which the conversion was anti-dilutive does not matter, and those periods would not be excluded from the nine- and twelve-month year-to-date calculations. Example 1 (transaction e) in ASC 260-10-55 illustrates this point. Note: This would also be true if FSP Corp was profitable in all quarters, but the application of the if-converted method was still anti-dilutive in the first and second quarters due to the add-back per common share exceeding basic EPS. This is different than the treatment of treasury stock method shares in year-to-date diluted EPS computations, as described in FSP 7.5.5.7.

   Question FSP 7-3
   In the second quarter, FSP Corp declared and paid a special dividend to holders of common stock. As a result, the conversion rate on FSP Corp's convertible notes was reduced in accordance with their contractual terms. How should the change in the conversion rate be treated for purposes of computing diluted EPS?

   PwC response We believe that either of the following approaches would be acceptable.
   • By analogy to ASC 260-10-45-42 (which addresses convertible securities issued, converted, or extinguished during the period), FSP Corp could calculate the number of shares to include in the denominator for the period by adding:
     • the number of shares issuable based on the conversion rate in effect before the special dividend, weighted for that period, and
     • the number of shares issuable based on the new conversion rate, weighted for the appropriate period.

     Choosing which approach to follow is an accounting policy decision and should be consistently applied in all periods for similar instruments.

     7.5.6.1 Treatment of capitalized interest on convertible debt—after adoption of ASU 2020-06

     Capitalized interest from convertible debt could present a conceptual problem in applying the if-converted method. Application of the if-converted method requires the add-back of interest expense and certain other non-discretionary adjustments to net income when convertible securities are assumed to be converted. Accordingly, when any portion of convertible debt interest has been capitalized during a period, it is appropriate, in the EPS computations only, to assume that such interest was not incurred during the period and, therefore, neither capitalized nor expensed, and to make an “as-if” recomputation of interest that would have been capitalized based on interest on other debt.

     In this situation, the reporting entity would adjust the numerator to eliminate any effect of the convertible debt interest that was expensed and any other interest expense that would have been capitalized on other debt instruments had the convertible debt not been in existence. As usual, the effect of the “if converted” method cannot be anti-dilutive.

     To illustrate, assume a reporting entity has convertible debt that is included using the “if-converted” method for diluted EPS purposes. In general, the reporting entity should determine the amount of interest related to the convertible security included in interest expense and include only that amount (net of tax) in the “if-converted” method calculation. In other words, the reporting entity should not add back to the numerator of diluted EPS the interest attributable to convertible debt that has been capitalized based upon the requirements of ASC 835-20.

     The rationale is that capitalized interest is, by definition, not an expense of the current period and, therefore, assumed conversion of the debt at the beginning of the current period generally would not have affected net income if the interest was capitalized. However, the reporting entity should consider whether assumed conversion at the beginning of the period would have affected the overall amount of interest capitalized on other debt, and thus income. The reporting entity should perform a “with conversion” and “without conversion” calculation of capitalized interest to determine if assumed conversion at the beginning of the period would have affected income. If the capitalized interest would have been different if conversion had occurred at the beginning of the period, the reporting entity should treat that difference as a nondiscretionary amount and include it as an adjustment in the diluted EPS computation in accordance with ASC 260-10-45-40.

     7.5.6.2 Partial redemption or induced conversion on diluted EPS—after adoption of ASU 2020-06

     As discussed in FSP 7.4.1.3 and FSP 7.5.6, a reporting entity may offer an incentive to preferred stockholders to either redeem or convert their outstanding shares.

     If a reporting entity effects a redemption or induced conversion of only a portion of the outstanding securities of a class of preferred stock, any excess consideration is attributed to only those shares that are redeemed or converted. ASC 260-10-S99-2 indicates that, in determining the dilutive effect of the preferred stock, each group—those remaining outstanding and those redeemed or converted—are considered separately, as they have different effective dividend yields resulting from the excess consideration.

     Example FSP 7-20 illustrates how to determine if assumed conversion is dilutive when a portion of outstanding preferred stock securities are redeemed during the period.

     EXAMPLE FSP 7-20
     Determining whether redemption of a portion of outstanding preferred shares is dilutive

     FSP Corp has shares of common stock and 100 shares of convertible preferred stock outstanding at the beginning of a period.

     The convertible preferred stock was issued at fair value, which was equal to its stated value of $10 per share and a stated dividend of 5%. Each share of preferred stock is convertible into one share of common stock.

     During the reporting period, 20 preferred shares were redeemed at a per share price of $12. How should FSP Corp determine whether conversion is dilutive? Analysis

     FSP Corp should apply the guidance in ASC 260-10-S99-2 and determine whether conversion is dilutive (1) for 80 of the preferred shares (the shares remaining outstanding) by applying the if-converted method from the beginning of the period to the end of the period using the stated dividend of 5%, and (2) for the 20 shares redeemed by applying the if-converted method from the beginning of the period to the date of redemption, using both the stated dividend of 5% and the $2 per share redemption premium.

     7.5.6.3 Contingently convertible instruments—after adoption of ASU 2020-06

     Some conversion options can only be exercised by the holder upon satisfaction of a contingency. There are two broad categories of conversion option contingencies:

     • Contingencies tied to the issuer’s stock price

     If the instrument’s conversion is based on achieving a substantive contingency based on an event or index other than the issuer’s stock price, the reporting entity would not include the instrument in diluted EPS until the non-market based contingency has been met or is being met based on circumstances at the end of the reporting period, consistent with the guidance in ASC 260-10-45-48. For example, if the contingency was based on an IPO, and an IPO had not been completed by period end, the contingently convertible instruments would not be included in diluted EPS for the period.

     However, based on the guidance in ASC 260-10-45-44, contingently convertible instruments that are tied to the reporting entity’s stock price should be treated in the same manner as other convertible securities and included in diluted EPS, if the effect is dilutive, regardless of whether the stock price trigger has been met.

     Further, delayed convertibility based solely on the passage of time does not avoid including the security immediately pursuant to the if-converted method based on the requirements above, even if the security is not convertible for many years.

     Figure FSP 7-8 illustrates the treatment of the two types of conversion contingencies. Figure FSP 7-8
     EPS treatment of contingently convertible securities in diluted EPS

     ASC 260-10-45-44 applies to all issued securities that have embedded market-price-contingent conversion features, including contingently convertible debt, contingently convertible preferred stock, and convertible debt for which, upon conversion, the issuer must satisfy the principal amount of the debt in cash and may satisfy the conversion premium in either cash or stock. ASC 260-10-45-44 does not cover freestanding instruments and contingent conversion features that are based on a contingency other than a market price trigger, nor does it apply to stock warrants or options that are only exercisable upon achieving a market condition (see FSP 7.5.3).

     The diluted EPS calculation should use the if-converted method regardless of the terms of the security as follows:

     • If upon conversion, the reporting entity could deliver the full number of shares, it should use the approach described in ASC 260-10-45-40 through ASC 260-10-45-42.
     • If upon conversion, the reporting entity is required to deliver cash for the par value of the security and could deliver shares only for the differential between the stock price and the conversion price, it should use the approach described in ASC 260-10-55-84 through ASC 260-10-55-84B.

     7.5.6A If-converted method for convertible securities—before adoption of ASU 2020-06

     ASC 260 considers all convertible securities, including convertible debt and convertible preferred stock, which by their terms may be converted into common stock of the reporting entity, as potential common shares.

     Share-settled convertible debt and convertible preferred stock are generally included in diluted EPS using the if-converted method described in ASC 260-10-45-40. However, convertible debt with a cash conversion feature, specifically Instrument C (as discussed in FG 6.6A and FSP 7.5.6.3A), is typically included in diluted EPS using the net share settlement method described at ASC 260-10-55-84 through ASC 260-10-55-84B.

     Definition from ASC 260-10-20

     If-converted method: A method of computing EPS data that assumes conversion of convertible securities at the beginning of the reporting period (or at time of issuance, if later).

     Under the “if-converted” method:
     • If a reporting entity has convertible preferred stock outstanding, it adds back the preferred dividends (declared or cumulative undeclared) applicable to the convertible preferred stock in the period to the diluted EPS numerator. Such add-back would also include deemed dividends in the period from amortization of a beneficial conversion feature, any adjustments charged or credited to equity in the period to accrete preferred stock classified as mezzanine equity to its cash redemption price (or recorded upon a redemption or induced conversion), and any participating dividends allocated to the convertible preferred stock in the period for purposes of basic EPS.
     • If a reporting entity has convertible debt outstanding, the reporting entity should:

     (1) Add back interest charges applicable to such convertible debt in the period, including interest expense from the amortization of a BCF, to the numerator,

     (2) Adjust the numerator if nondiscretionary adjustments based on income made during the period would have been computed differently had the interest on convertible debt not been recognized, and

     (3) Adjust the numerator for the income tax effect of adjustments (1) and (2), computed on a “with or without” basis. See TX 9.4.6 for tax considerations related to BCF on convertible debt.

     Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.

     When the conversion feature embedded in a convertible debt instrument is bifurcated from the debt host and accounted for separately pursuant to the derivative accounting literature, the debt host and the separated conversion feature are each treated as a separate unit of account. The discount created on the debt by separation of the conversion feature should be amortized through interest expense over the contractual life of the debt, and the conversion feature should be marked to fair value each reporting period with changes in fair value included in earnings.

     Despite the fact that the debt and conversion feature are considered separate units of account for accounting purposes, they are treated as one instrument for EPS purposes (as it is a single convertible debt instrument) and included in the diluted EPS calculation using the if-converted method.

     In addition to the adjustment for interest expense (which includes amortization of the discount created upon bifurcation of the conversion option from the debt), the mark-to-market gain or loss each period related to the bifurcated conversion option should be deducted from/added back to the numerator (adjusted for any tax effect) in calculating diluted EPS.

     As discussed further in FSP 7.5.7.1A, ASC 260-10-55-32 requires reporting entities to exclude the income statement impact of instruments assumed to be settled in shares for EPS purposes, and that are required to be reported as assets or liabilities, from the numerator in the diluted EPS calculation. The mark-to-market adjustment is nondiscretionary in all periods, whether a gain or loss, and so should be deducted from/added to the numerator. As a result of the adjustments to the diluted EPS numerator for the interest expense and mark-to-market gain or loss, and the denominator adjustment for the number of shares assumed to be converted, the security may be dilutive or antidilutive. If antidilutive, the security should be excluded from the diluted EPS calculation altogether.

     If a reporting entity enters into an interest rate swap as a hedge of the interest associated with convertible debt that automatically terminates upon settlement or conversion of the debt (i.e., termination is nondiscretionary), the interest expense adjustment to the numerator is inclusive of the impact of the interest rate swap. If the swap arrangement does not automatically terminate upon conversion, the reporting entity should exclude the impact of the swap from the add-back and add back only the contractual interest on the debt in the numerator.

     Conversion is not assumed for purposes of computing diluted EPS if the effect would be anti-dilutive, such as in the following situations:

     • Convertible debt is anti-dilutive when its interest and nondiscretionary adjustments (net of tax) per common share obtainable on conversion exceeds basic EPS.
     • Convertible preferred stock is anti-dilutive when the amount of the dividend declared in, or accumulated for, the current period, including any deemed dividends or related accretion and participation in dividends, per common share obtainable on conversion exceeds basic EPS.

     Similarly, in periods of net loss, the application of the if-converted method to convertible securities is generally anti-dilutive (see FSP 7.5.7.1A for a situation where it may not be).

     The if-converted calculations are not affected by the reporting entity’s current stock price in relation to the conversion price. That is, a convertible security has the same effect on diluted EPS when the conversion option is far out of the money (i.e., the security has little chance of being converted), as it does when it is deep in the money (i.e., the security has a high likelihood of being converted).

     Reporting entities should include convertible securities that have a dilutive effect on EPS in the denominator of diluted EPS from the beginning of the period or from the date of issuance, if later. They should also include dilutive convertible securities that are extinguished or redeemed, and securities in which the conversion options lapsed, in the denominator for the period they were outstanding. Consistent with ASC 260-10-S99-2, in circumstances when dilutive convertible securities are extinguished or redeemed and there is a gain or loss on extinguishment or induced conversion reflected in the numerator of basic EPS, that gain or loss should be reversed in the numerator of diluted EPS because the shares are assumed to have been converted at the beginning of the period.

     If the number of shares to be issued upon conversion varies based on (1) the stock price at the conversion date, (2) an average of stock prices around the conversion date, or (3) a formula based on stock prices, the reporting entity should determine the number of shares included in the diluted EPS denominator by applying the conversion formula to the corresponding stock prices at the end of the reporting period. For example, if the number of shares issued upon conversion is based on the average stock price for the 10 days prior to conversion, the stock price on the last 10 days of the reporting period should be used to calculate the number of shares included in the diluted EPS denominator for the period.

     Dilutive convertible securities converted during the period are included in the denominator of diluted EPS for the period prior to their conversion. Thereafter, the shares issued are included in the denominator of both basic and diluted EPS.

     Example FSP 7-18A and Example FSP 7-19A illustrate the application of the if-converted method for convertible debt before ASU 2020-06.

     EXAMPLE FSP 7-18A
     Application of the if-converted method to convertible debt – before ASU 2020-06

     On January 1, 20X7, FSP Corp issued $10 million of convertible bonds (10,000 bonds in $1,000 increments), at par. On the issuance date, FSP Corp’s common stock price was $100 per share. The terms of the bonds include:

     • A coupon rate of 2% per year, which results in after-tax interest expense of $30,000 per quarter ($10 million x 2% x 1/4 = $50,000 less income tax of $20,000 (40% tax rate x $50,000)).
     • A requirement that FSP Corp deliver 8 shares per bond to bond holders upon conversion (which equates to a conversion price of $125), or 80,000 shares (10,000 bonds x 8 shares per bond) in total.

     FSP Corp has 10 million weighted average common shares outstanding, and net income for the quarter ended March 31, 20X7 is $50 million.

     How should FSP Corp include the convertible bonds in the diluted EPS computation for the period ended March 31, 20X7?

     Analysis

     FSP Corp should include the convertible bonds in diluted EPS using the if-converted method, if it is dilutive.

     Adjustments Diluted EPS Weighted average common shares and potential common shares

     EXAMPLE FSP 7-19A
     Computing year-to-date diluted EPS when convertible debt is anti-dilutive in certain periods and dilutive in others – before ASU 2020-06

     FSP Corp is profitable for the year but has net losses in the first and second quarters of 20X7. FSP Corp issued convertible debt in the prior year, which has been outstanding for all of 20X7.

     When adding back interest expense on the convertible debt and adjusting the weighted average shares to reflect conversion at the beginning of those periods, the results are anti-dilutive for both the discrete quarters and for the year-to-date EPS computation for the first and second quarters. The result of assuming conversion in the third and fourth quarters is dilutive.

     How would FSP Corp compute year-to-date EPS for the third and fourth quarters of 20X7? Analysis

     For the nine- and twelve-month period computations, the assessment of whether the convertible debt is anti-dilutive should consider the entire period for which the convertible debt was outstanding (the nine- or twelve-month periods). The fact that there are discrete quarters in which the conversion was anti-dilutive does not matter, and those periods would not be excluded from the nine- and twelve-month year-to-date calculations. Example 1 (transaction e) in ASC 260-10-55 illustrates this point. Note: This would also be true if FSP Corp was profitable in all quarters, but the application of the if-converted method was still anti-dilutive in the first and second quarters due to the add-back per common share exceeding basic EPS. This is different than the treatment of treasury stock method shares in year-to-date diluted EPS computations, as described in FSP 7.5.5.7.

     Question FSP 7-3A
     In the second quarter, FSP Corp declared and paid a special dividend to holders of common stock. As a result, the conversion rate on FSP Corp's convertible notes was reduced in accordance with their contractual terms. How should the change in the conversion rate be treated for purposes of computing diluted EPS?

     PwC response We believe that either of the following approaches would be acceptable.
     • By analogy to ASC 260-10-45-42 (which addresses convertible securities issued, converted, or extinguished during the period), FSP Corp could calculate the number of shares to include in the denominator for the period by adding:
       • the number of shares issuable based on the conversion rate in effect before the special dividend, weighted for that period, and
       • the number of shares issuable based on the new conversion rate, weighted for the appropriate period.

       Choosing which approach to follow is an accounting policy decision and should be consistently applied in all periods for similar instruments.

       In addition, FSP Corp should consider whether the change in the conversion rate creates a contingent beneficial conversion feature under the guidance in ASC 470-20-25-20.

       7.5.6.1A Treatment of capitalized interest on convertible debt—before adoption of ASU 2020-06

       Capitalized interest from convertible debt could present a conceptual problem in applying the if-converted method. Application of the if-converted method requires the add-back of interest expense and certain other non-discretionary adjustments to net income when convertible securities are assumed to be converted. Accordingly, when any portion of convertible debt interest has been capitalized during a period, it is appropriate, in the EPS computations only, to assume that such interest was not incurred during the period and, therefore, neither capitalized nor expensed, and to make an “as-if” recomputation of interest that would have been capitalized based on interest on other debt.

       In this situation, the reporting entity would adjust the numerator to eliminate any effect of the convertible debt interest that was expensed, and to eliminate any other interest expense that would have been capitalized on other debt instruments had the convertible debt not been in existence. As usual, the effect of the “if converted” method cannot be anti-dilutive.

       To illustrate, assume a reporting entity has convertible debt that is included using the “if-converted” method for diluted EPS purposes. In general, the reporting entity should determine the amount of interest related to the convertible security included in interest expense and include only that amount (net of tax) in the “if-converted” method calculation. In other words, the reporting entity should not add back to the numerator of diluted EPS the interest attributable to convertible debt that has been capitalized based upon the requirements of ASC 835-20.

       The rationale is that capitalized interest is, by definition, not an expense of the current period and, therefore, assumed conversion of the debt at the beginning of the current period generally would not have affected net income if the interest was capitalized. However, the reporting entity should consider whether assumed conversion at the beginning of the period would have affected the overall amount of interest capitalized on other debt, and thus income. The reporting entity should perform a “with conversion” and “without conversion” calculation of capitalized interest to determine if assumed conversion at the beginning of the period would have affected income. If the capitalized interest would have been different if conversion had occurred at the beginning of the period, the reporting entity should treat that difference as a nondiscretionary amount and include that amount as an adjustment in the diluted EPS computation in accordance with ASC 260-10-45-40.

       7.5.6.2A Partial redemption or induced conversion on diluted EPS—before adoption of ASU 2020-06

       As discussed in FSP 7.4.1.3A and FSP 7.5.6A, a reporting entity may offer an incentive to preferred stockholders to either redeem or convert their outstanding shares.

       If a reporting entity effects a redemption or induced conversion of only a portion of the outstanding securities of a class of preferred stock, any excess consideration is attributed to only those shares that are redeemed or converted. ASC 260-10-S99-2 indicates that, in determining the dilutive effect of the preferred stock, each group—those remaining outstanding and those redeemed or converted—are considered separately, as they have different effective dividend yields resulting from the excess consideration.

       Example FSP 7-20A illustrates how to determine if assumed conversion is dilutive when a portion of outstanding preferred stock securities are redeemed during the period before adoption of ASU 2020-06.

       EXAMPLE FSP 7-20A
       Determining whether redemption of a portion of outstanding shares is dilutive – before ASU 2020-06

       FSP Corp has shares of common stock and 100 shares of convertible preferred stock outstanding at the beginning of a period.

       The convertible preferred stock was issued at fair value, which was equal to its par value of $10 per share, has a stated dividend of 5%, and each share of preferred stock is convertible into one share of common stock.

       During the reporting period, 20 preferred shares were redeemed at a per share price of $12. How should FSP Corp determine whether conversion is dilutive? Analysis

       In this example, FSP Corp should apply the guidance in ASC 260-10-S99-2 and determine whether conversion is dilutive (1) for 80 of the preferred shares (the shares remaining outstanding) by applying the if-converted method from the beginning of the period to the end of the period using the stated dividend of 5%, and (2) for the 20 shares redeemed by applying the if-converted method from the beginning of the period to the date of redemption, using both the stated dividend of 5% and the $2 per share redemption premium.

       7.5.6.3A Convertible debt with a cash conversion feature—before adoption of ASU 2020-06

       Traditional share-settled convertible debt provides the holder with the full number of shares underlying the bond upon conversion (i.e., no cash is received). However, a convertible bond with a cash conversion feature allows the issuer to settle its obligation upon conversion, either in whole or in part, in a combination of cash or stock, either mandatorily or at the issuer’s option. Convertible debt with a cash conversion feature (FG 6.6A) in which the principal amount must be settled in cash is not included in diluted EPS using the if-converted method.

       Figure FSP 7-7A illustrates the treatment of these instruments, which is discussed further in ASC 260-10-55-84 through ASC 260-10-55-84B.

       Figure FSP 7-7A
       EPS treatment of convertible debt with a required cash conversion feature

       The number of shares included in the denominator of diluted EPS is determined by dividing the “conversion spread value” of the share-settled portion of the instrument by the share price. The “conversion spread value” is the value that would be delivered to investors in shares based on the terms of the bond upon an assumed conversion. An issuer should elect a policy of determining the share price to be used to calculate the number of shares included in diluted EPS. We believe it is permissible to use either (1) an average share price over the reporting period, or (2) the share price formula stated in the agreement, which would be applied to the corresponding stock prices at the end of the period.

       However, the issuer of a debt instrument that may settle in any combination of cash or stock at the issuer’s option (known in practice as an “Instrument X” bond) should consider the guidance on instruments settleable in cash or shares. See FSP 7.5.7.1A for details.

       7.5.6.4A Contingently convertible instruments—before adoption of ASU 2020-06

       Some conversion options can only be exercised by the holder upon satisfaction of a contingency. There are two broad categories of conversion option contingencies:

       • Contingencies tied to the issuer’s stock price

       If the instrument’s conversion is based on achieving a substantive contingency based on an event or index other than the issuer’s stock price, the reporting entity would not include the instrument in diluted EPS until the non-market based contingency has been met or is being met based on circumstances at the end of the reporting period, consistent with the guidance in ASC 260-10-45-48. For example, if the contingency was based on an IPO, and an IPO had not been completed by period end, the contingently convertible instruments would not be included in diluted EPS for the period.

       However, based on the guidance in ASC 260-10-45-44, contingently convertible instruments that are tied to the reporting entity’s stock price should be treated in the same manner as other convertible securities and included in diluted EPS, if the effect is dilutive, regardless of whether the stock price trigger has been met.

       Further, delayed convertibility based solely on the passage of time does not avoid including the security immediately in the if-converted method based on the requirements above, even if the security is not convertible for many years.

       Figure FSP 7-8A illustrates the treatment of the two types of conversion contingencies. Figure FSP 7-8A
       EPS treatment of contingently convertible securities in diluted EPS

       ASC 260-10-45-44 applies to all issued securities that have embedded market-price-contingent conversion features, including contingently convertible debt, contingently convertible preferred stock, and convertible debt for which, upon conversion, the issuer must satisfy the principal amount of the debt in cash, and may satisfy the conversion premium in either cash or stock. ASC 260-10-45-44 does not cover freestanding instruments and contingent conversion features that are based on a contingency other than a market price trigger, nor does it apply to stock warrants or options that are only exercisable upon achieving a market condition (see FSP 7.5.3).

       The diluted EPS calculation depends on the terms of the security as follows:
       • If upon conversion, the reporting entity could deliver the full number of shares, it should use the if-converted method.
       • If upon conversion, the reporting entity is required to deliver cash for the par value of the security and could deliver shares only for the differential between the stock price and the conversion price, it should use the net share settlement method described in ASC 260-10-55-84 through ASC 260-10-55-84B.

       7.5.7 Other arrangements potentially impacting diluted EPS

       There are various other arrangements that could result in the issuance of additional shares of stock by the reporting entity and, therefore, impact the computation of diluted EPS. These include: financial instruments settleable in cash or shares, subsidiary share agreements, and escrow share arrangements.

       7.5.7.1 Instruments settleable in cash or shares—after adoption of ASU 2020-06

       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 7.5.6.3.

       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.

       Year-to-date computations for liability-classified instruments-after adoption of ASU 2020-06

       In year-to-date diluted EPS calculations that require an adjustment to the numerator, ASC 260-10-55-34 states that the numerator adjustment should be equal to the earnings effect of the change in the fair value of the asset or liability recorded pursuant to ASC 815-40-35 for the year-to-date period. This same guidance indicates that the number of incremental shares included in the denominator should be determined in accordance with the guidance in ASC 260-10-55-3. ASC 260-10-55-3 states that for year-to-date diluted EPS, the number of incremental shares to be included in the denominator should be determined by computing a year-to-date weighted average of the number of incremental shares included in each quarterly diluted EPS computation.

       Adjusting the numerator in the computation of diluted EPS pursuant to the treasury stock method based on the earnings effect of marking the liability-classified instrument to market for the year-to-date period, while including potential common shares in the denominator based on the weighted average incremental shares included in each quarterly period (based on the average stock price in each quarter), may lead to counterintuitive results. For example, if the warrants were out-of-the-money for one or more quarters, one may question whether the numerator adjustment should reflect the year-to-date earnings effect or only for the earnings effect of the quarters when potential common shares are being included in the denominator. Despite results that may seem counterintuitive in certain fact patterns, ASC 260-10-55-34 is clear that the numerator adjustment for these instruments must be based on the earnings effect for the year-to-date period.

       In applying the treasury stock method for year-to-date computations, ASC 260-10-55-3A and 55-3B must be considered:

       Computation of year-to-date diluted EPS when an entity has a year-to-date loss from continuing operations including one or more quarters with income from continuing operations and when in-the-money options or warrants were not included in one or more quarterly diluted EPS computations because there was a loss from continuing operations in those quarters is as follows. In computing year-to-date diluted EPS, year-to-date income (or loss) from continuing operations shall be the basis for determining whether or not dilutive potential common shares not included in one or more quarterly computations of diluted EPS shall be included in the year-to-date computation.

       a. When there is a year-to-date loss, potential common shares should never be included in the computation of diluted EPS, because to do so would be antidilutive.

       b. When there is year-to-date income, if in-the-money options or warrants were excluded from one or more quarterly diluted EPS computations because the effect was antidilutive (there was a loss from continuing operations in those periods), then those options or warrants should be included in the diluted EPS denominator (on a weighted average basis) in the year-to-date computation as long as the effect is not antidilutive. Similarly, contingent shares that were excluded from a quarterly computation solely because there was a loss from continuing operations should be included in the year-to-date computation unless the effect is antidilutive.

       ASC 260-10-55-3B(b) may suggest that the determination of which warrants to include in the calculation of the diluted EPS denominator should solely be based on whether there is income or loss from continuing operations in a period. However, we believe that that would be an overly literal read of this guidance.

       Consider in-the-money liability-classified warrants that were excluded from one or more quarterly diluted EPS computations because after considering the numerator adjustment for the earnings effect of the change in the fair value of the asset or liability recorded pursuant to ASC 815-40-35, as well as the incremental shares to be included in the denominator pursuant to the treasury stock method, the aggregate effect was antidilutive for the quarter. Assume that these same warrants are dilutive considering the numerator adjustment for the earnings effect of the change in the fair value of the asset or liability, as well as the incremental shares to be included in the denominator pursuant to the treasury stock method for the year-to-date period.

       We believe that a reporting entity should include these warrants in the year-to-date computation of diluted EPS, assuming the effect is dilutive. When evaluating the effect of the liability classified warrant on diluted EPS for the year-to-date period, the denominator impact should be the number of incremental shares that were calculated for each quarter using the treasury stock method (even if ultimately those shares were not included in diluted EPS because the combined effect of the numerator adjustment and denominator adjustment was anti-dilutive for that quarter). In other words, the YTD calculation of the effect of the warrant should consider the average of the quarterly incremental shares based on the treasury stock method calculation/average stock price in the denominator, and the year-to-date numerator adjustment. Those two effects would be evaluated together to determine whether the warrant is dilutive or anti-dilutive for the year-to-date diluted EPS computation.

       7.5.7.1A Instruments settleable in cash or shares—before adoption of ASU 2020-06

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

       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
       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 7-21A illustrates the impact of a liability-classified warrant on the computation of diluted EPS.

       EXAMPLE FSP 7-21A
       Determining whether cash or share settlement is more dilutive for a liability-classified warrant – before ASU 2020-06

       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.