The staff of the Financial Accounting Standards Board (FASB) has, it seems, increased the rate at which accounting guidance is being issued. The latest offering involves a clarification of the manner in which earnings per share (EPS) is calculated for entities which have issued “participating securities,” in addition to common stock,
Indeed, FAS 128, Earnings Per Share, defines EPS as “the amount of earnings attributable to each share of common stock.” The board decided to require, with respect to the computation of EPS, the use of the so-called “two class method” in the case of enterprises with participating securities. The two-class method (see paragraph No. 59 of FAS 128) is an earnings allocation formula that determines EPS for each class of common stock and participating securities according to dividends distributed and participation rights in undistributed earnings.
For this purpose, participating securities include securities that may participate in dividends with common stock according to a pre-determined formula with, at times, an upper limit on the extent of participation. In light of this definition, the FASB staff has concluded, in FSP EITF 03-6-1, June 16, 2008, that unvested, share-based payment awards that contain non-forfeitable rights to dividends (or dividend equivalents) constitute participating securities. This is so because, in these cases, the holder receives a non-contingent “transfer of value” each time an entity declares a dividend during the contractual period of the award.
Accordingly, the award meets the definition of a participating security prior to the requisite service having been rendered for the award. By contrast, the right to receive dividends that the holder will forfeit if the award does not vest does not constitute a participation right. Therefore, such an award does not meet the definition of a participating security. Moreover, a right to dividends in the form of a reduction in the exercise price of a share-based payment award is merely a contingent transfer of value to the holder of the award. Which means, again, that the award does not meet the definition of a participating security.
These rules will be effective with respect to financial statements issued for fiscal years beginning after December 15, 2008. Further, all prior period “EPS data” shall be adjusted retrospectively to conform to the principles of the FSP. Early adoption of the FSP is, however, not permitted.
Case in Point
Here’s an example that will help explain the practical effects of the rule change.
Alpha Corp. has outstanding 25,000 shares of common stock and 5,000 unvested, share-based payment awards. For 2008, Alpha has net income of $100,000. The share-based payment awards participate in dividends on a 1:1 per-share ratio with the common stock and, most notably, such dividends are non-forfeitable.
At the beginning of 2008, Alpha expects that the requisite service will not be performed for 200 of the share-based payment awards. At the end of 2008, Alpha’s's judgment changes and it expects, at that time, that the requisite service will not be performed for 300 of the share-based payment awards. At the end of 2008, Alpha pays a dividend of $1.50 per share at the end of 2008.
Alpha’s net income (of $100,000) includes an expense of $450 (300 awards multiplied by $1.50 per award) relating to dividends paid on awards with respect to which the requisite service is not expected to be rendered.
In this case, Alpha’s “undistributed earnings” (for purposes of the two-class method) amounts to $55,450, which is the net income of $100,000 reduced by: (1) the dividends paid on the common stock, which amounts to $37,500 and; (2) the dividends paid on the unvested share based payment awards, $7,500, reduced by (3) the dividends paid on those awards for which the requisite service is not expected to be rendered, $450 — an amount already reflected in net income.
As a result, Alpha’s basic EPS amounts are as follows:
• Distributed Earnings Unvested share based payment awards: $1.41 ($7,050 divided by 5,000 — remember only dividends paid on awards for which the requisite service is expected to be rendered are considered “distributed earnings.”
• Common stock: $1.50
• Unvested share based payment awards: $1.85 ($55,450 divided by 30,000; the sum of the common shares and share based payment awards outstanding.)
• Common stock: $1.85
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.