How are EPS computations affected?
Guidance on earnings per share (EPS) computations is provided by FASB Statement No. 128, Earnings Per Share. Statement 128 requires options, nonvested and restricted shares, and other awards granted to employees to be treated as potential common stock in computing diluted EPS using the treasury stock method. This calculation is based upon the actual number of shares or options granted and not forfeited, without reduction for expected forfeitures. That is, EPS computations are based on the full number of outstanding awards, whereas compensation expense is accrued only for awards expected to vest. Under the treasury stock method, proceeds include the following:
- Amount employee will pay, if any, plus
- Unearned compensation, if any, plus or (minus)
- The amount of tax benefit that would be credited or (debited) to APIC if the tax deduction were measured based on the current stock price.
Statement 128 treats awards that are contingent on performance or market conditions as contingently issuable shares.
While Statement 123(R) does not change the mechanics of the computations for diluted earnings per share (EPS), it poses some challenges that companies need to be aware of. In particular, companies that granted predominantly options that had zero compensation expense under Opinion 25 had no unearned compensation and no deficient tax benefits to reflect in EPS computations in the past. Although companies had excess tax benefits, some ignored the excess tax benefits in computing diluted EPS. Under Statement 123(R), those companies should upgrade their EPS computations to capture unearned compensation and excess and deficient tax benefits.
As mentioned previously, the FASB's Statement 123(R) Resource Group is wrestling with some narrowly-defined issues. Two of these relate to EPS computations16. In particular, the Resource Group has discussed and provided guidance relating to the following:
- Question: How should a company compute diluted EPS for share-based payment awards that are currently out-of-the-money (i.e., exercise price is greater than the average market price) if the tax deficiency that would be debited to APIC (and therefore would serve to reduce assumed proceeds) would make the award dilutive?
- Answer: The treasury stock method was only intended to capture awards that would actually be exercised and converted into common shares. Therefore, out-of-the-money awards would be excluded from the computation.
- Question: For awards granted prior to transition to Statement 123(R), should adjustments for excess deferred tax benefits or deferred tax asset write-offs affecting APIC be (a) based on amounts that would actually be recognized or (b) adjusted for any pro forma deferred tax assets?
- Answer: Originally the Resource Group indicated companies should follow pro forma balances as if the company always had been following a fair value measurement principle. However, in light of the permitted short-cut method to compute the opening balance of the APIC pool, the Resource Group plans to reconsider this guidance in a future meeting.
16 Refer to the Statement 123(R) Resource Group Meeting No. 3 - September 13, 2005, General Implementation Matters - Issues 2 and 3.
Continue Reading - What are other implementation issues to consider?