Earnings per share, or EPS, is a required disclosure under ASC 260 for public companies. While entities do not have a contractual obligation to repay equity interest holders, the EPS profitability metric provides insight for financial statement users about the quality of earnings available for distribution to equity interest holders each reporting period. In other words, this required disclosure represents the size of a slice of an entity’s profitability pie.
There are two calculations of EPS required by ASC 260: basic EPS and diluted EPS. Basic EPS uses an “actual” filter and calculates the income available to common shareholders by the weighted average number of common shares outstanding during a period. Diluted EPS uses a “hypothetical” filter and calculates the income available to all potential ownership interests. This blog highlights some considerations specific to diluted EPS, themed to a classic tune from the band Filter, Welcome to the Fold.
…You take my money
In general, entities enter into financing arrangements with other parties through the use of debt instruments or equity instruments. The issuance of debt instruments represents a borrowing of funds that must be repaid at a future date. On the other hand, the issuance of equity instruments provides the holder an ownership interest without an obligation to repay funds received at a future date. Sometimes, financing instruments may include characteristics of both debt and equity. These hybrid instruments may be classified as equity only after extensive review of terms and conditions as well as addressing considerations in both ASC 480 and ASC 815.
EPS focuses on measuring an entity’s profitability in terms of what would be available to those parties with an ownership stake. So, the two financing arrangements that may result in an ownership interest and thus would need to be evaluated when calculating diluted EPS are equity instruments and hybrid instruments.
You’re celebrating nothing…
The purpose of diluted EPS is to measure the quality of an entity’s earnings that would be available to all current and potential shareholders. Unlike basic EPS, this calculation places equal emphasis of actual and constructive equity holders. The more equity holders are welcomed into the fold, the smaller the size of each slice of pie each reporting period. Keep in mind, only potential shares that are dilutive are included (meaning, diluted EPS should be a lower value when compared with basic EPS). There is a process to calculate diluted EPS:
Step 1: Identify all instruments for which an entity may potentially issue common shares
Each instrument should be evaluated separately each period to determine whether potential shares are dilutive in nature. An entity determines dilution by using different methods based on the type of instruments issued:
Treasury stock method
Options, warrants, share-based payment awards, forward contracts, unit structures, employee stock purchase plans, contingently issuable shares
Convertible debt, convertible preferred stock, contingently issuable shares
Reverse treasury stock method
Written put options, forward purchase contracts
Step 2: Calculate the dilutive (or antidilutive) effect of each instrument identified in Step 1
Let’s review how to apply the treasury stock method to options and warrants as an example. The treasury stock method assumes that options and warrants result in the issuance of shares. The entity then uses the proceeds from the issuance of these instruments to repurchase common shares outstanding. If the exercise price of the options and warrants is lower than the average price of common shares during the period, the instruments would be “in-the-money” and have a dilutive effect on EPS. That’s because more shares would be issued than could be potentially repurchased by the entity. If the exercise price of the options and warrants is higher than the average price of common shares during the period, the instruments would be “out-of-the-money” and result in an antidilutive effect on EPS.
So, how should an entity compute the average market price of common shares during a period? ASC 260 requires that the average price should be “meaningful,” but does indicate that a simple average of weekly or monthly prices may very well suffice. Whatever the convention selected, the key is to consistently apply this each period.
Step 3: Sequence each instrument identified in Step 1
Once an entity calculates the dilutive effect of each equity instrument, sequencing must then occur. An entity must then rank each instrument that can potentially be settled by the issuance of ownership interests. An entity derives the rank of an instrument by calculating the earnings per incremental share. The lower the earnings per incremental share, the more dilutive the instrument is to the EPS calculation. The last stage of the sequencing process is to order the ranked instruments from what is most dilutive to least dilutive to EPS. Then, the instruments are ready for Step 4!
Step 4: Apply the sequencing to the basic EPS calculation and cease once an instrument creates an antidilutive result
The third step is critical to the diluted EPS calculation. The order established in Step 3 really does matter, since an entity should not include instruments once the resulting calculation becomes antidilutive (i.e., the resulting EPS calculation is higher than before the inclusion of the instrument)! When this occurs, the process of calculating diluted EPS is complete!
…And you feel a-okay!
Calculating diluted EPS can become cumbersome when preparing both quarter-to-date and year-to-date disclosures. That is because all periods presented are discrete, and the calculation must be performed for each one without regard to another. For instance, if an entity recognizes a loss in its second quarter but still reports year-to-date income, the diluted EPS for the second quarter would not be presented because losses are antidilutive by definition. However, from a year-to-date perspective, the entity may still disclose diluted EPS as long as the impact of the potential exercise of the identified instruments was not antidilutive in nature.
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