Calculating Earnings Per Share

The FASB has targeted Statement No. 128, Earnings per Share, as one of the next areas of convergence with international accounting standards. The Board expects to issue an amendment early in 2005.

The process of deliberating and redeliberating the EPS standard was something of a balancing act for the FASB in 2004, as the EITF was also discussing emerging developments affecting EPS in the U.S. The EITF's consensuses added to the changes being considered as part of the FASB's short-term convergence project.

This standard-setting process left companies sorting through a maze of EPS guidance at year-end 2004. Some chose to rethink their capital structures because the accounting guidance includes EITF consensuses that could significantly reduce reported earnings per share, both basic and diluted.

The key reporting questions relate to participating and contingently convertible securities (co-cos), as well as possible restatements under the planned amendment.

Are participating securities properly reflected in basic EPS?

Basic earnings per share can be significantly reduced by the consensus reached on EITF Issue No. 03-6, "Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share." The changes introduced by Issue 03-6 have the effect of:

• Expanding the definition of participating securities to include options, warrants, and forward contracts with participating rights, and to include participating rights in forms other than direct sharing in dividends.
• Extending the required use of the two-class method for computing basic EPS to include participating convertible securities. The two-class method reduces basic EPS because it allocates earnings away from common shareholders toward other security holders based on their rights to receive benefits when dividends are declared. The EITF eliminated the alternative of using the if-converted method in basic EPS.

This guidance reflects a change in principle. EPS are lowered when earnings are allocated away from common shareholders and toward other security holders. Previously, the need to do so hinged mainly on the other security holder's right to receive undistributed earnings upon liquidation or redemption. Issue 03-6 changes the basis for the allocation. Now the need to allocate earnings away from common shareholders hinges on the other security holder's right to benefit from any dividends that might be declared by the company during the reporting period.

The consensus was effective for periods ended after March 31, 2004, and EPS for prior periods were restated retroactively to apply the consensus.

Are co-cos properly reflected in diluted EPS?

Diluted earnings per share can be significantly reduced by the consensus reached by the EITF in 2004 on Issue No. 04-8, "The Effect of Contingently Convertible Debt on Diluted EPS."

Issue 04-8 indicates that contingently convertible securities should be included in diluted EPS, regardless of whether market price conversion triggers have been met. This guidance represents a change from the treatment prescribed in Statement 128.

Initially, the FASB had planned to amend Statement 128 and make the EITF consensus effective concurrently with the amendment. More recently, due to delays in issuing the amendment, the FASB decided to make the consensus effective for periods ending after December 15, 2004.

Issue 04-8 applies to all securities that have embedded market price conversion features, including contingently convertible preferred stock.

Will the company's reported EPS need to be restated as a result of the coming amendment?

Restatements of EPS are possible as a result of the amendment expected early in 2005. The amendment is expected to include: (a) changes to the treasury stock method for year-to-date computations, (b) changes to the contingent share guidance for year-to-date computations, (c) the inclusion of mandatorily convertible securities in basic EPS calculations, (d) a requirement to include instruments with possible share settlements in diluted EPS even if the company has the right to settle in cash, and (e) application of the treasury stock method for an instrument that is classified as a liability but could potentially be settled in shares.

Until the amendment is issued and effective, instruments that can be settled either in cash or shares are presumed settled in shares for EPS purposes unless the company can overcome the presumption. The guidelines are as follows:

• The company must be able to provide a reasonable basis for overcoming a presumption that the instrument will be settled in shares.
• The reasonable basis might consist of the company's past practice or a stated policy that the obligation will be settled partially or wholly in cash rather than shares.

The amendment is expected to require companies to assume share settlement in all situations. If so, companies that under existing guidance overcome the presumption of share settlement will need to retroactively restate diluted EPS, unless they amended the terms of such instruments or settled them in cash before December 31, 2004.

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