EPS Hot Topics for Equity Compensation
Earnings per share is a core component of every public company’s financial statements. And — like many other areas of accounting — EPS has some aspects that accounting guidance from the Financial Accounting Standards Board doesn’t address, and other aspects that are simply difficult to unpack. Accounting Standards Codification Topic 260 (ASC 260) governs the presentation of EPS, including our focus here: share-based payments. These instruments are more complicated than they were when the standards were written, so best practices are still being developed.
In this blog post, we’ll share some of our institutional experience in serving clients and provide our theoretical perspectives on a few of the hottest topics in determining the impact of stock compensation on EPS. One of the most challenging topics within ASC 260 is the effect of awards containing performance and/or market conditions. These are becoming more popular every year, so we’ll start with them.
Awards with Market and Performance Conditions
Under ASC 260, the application of the treasury stock method seems straightforward:
- Determine the weighted shares outstanding
- Determine the assumed proceeds for all in-the-money outstanding instruments
- Compute hypothetical buyback shares using the average market price for the period
- Determine incremental dilutive shares as well as antidilutive shares
However, ASC 260 provides additional guidance for awards containing performance and/or market conditions. These shares are contingently issuable and therefore adjustments must be made to the target shares to determine the weighted shares outstanding.
The contingent share provisions specified in ASC 260-10-45-48 through 45-57 establish the rules regarding the timing and criteria in which awards with contingencies are included in diluted EPS. The bright line test is how many shares, if any, would be issued if the end of the financial reporting period were the end of the performance period.
In some cases, especially when awards are based on an absolute financial metric or stock price target, there could be a spike from zero issuable shares to a large number in the following reporting period. Since we’re not supposed to layer in assumptions about the future to determine issuable shares, the contingent shares that would be issued at the end of the current reporting period may be zero until the end of the performance period when there has been enough time for them to be earned.
In practice, some companies have used a more liberal interpretation regarding contingently issuable shares. For example, they may assume the company would modify or alter the payout rather than pay out nothing if the performance period was abbreviated. Another common assumption is that the current trend of performance would continue into the future (similar to expectations used for expense accruals). With these assumptions, at least a portion of the award is considered for dilution. Some defenders of this approach argue that including such incremental shares is conservative from a dilution standpoint.
However, we read ASC 260-10-45-51 (and 52) as imposing a fairly bright line when it says to assume that the “current amount of earnings will remain unchanged.” Calculating the trending of the metric and extrapolating it forward conflicts with that guidance and is especially troublesome for stock prices. While some aspects of ASC 260 could be more explicit, we feel the guidance is relatively clear about taking the current level of a given performance metric in determining issuable shares.
Another complication of these contingently issuable shares requires us to quickly introduce two concepts, expense multiplier and dilution multiplier.
- Expense multiplier is a multiplier applied to the target number of shares when expensing an award with a performance condition so that period accruals articulate to the then-probable outcome.
- Dilution multiplier is used to develop the number of issuable shares by scaling the target shares up or down per the contingency logic we described earlier.
The natural question is this: Which multiplier should be applied to determine the unrecognized compensation cost to determine the assumed proceeds for buying back shares? Given the dearth of information on this topic in ASC 260, we don’t believe a single interpretation is necessarily right or wrong (or consistent or inconsistent) with GAAP.
For awards containing any performance conditions, our own preference is to use the dilution multiplier. The reason is that this approach ensures internal consistency in the end-to-end calculations under the treasury stock method. For awards containing only market conditions, we lean toward using the expense multiplier when developing unrecognized compensation cost. That’s because a market-based award is valued using an option-pricing technique that embeds the impact of the market condition and therefore the final expense is a fixed amount as long as service is provided. If the dilution multiplier were used to develop unrecognized compensation cost for a market-based award, an inflated or deflated number of units would be hypothetically bought back.
For a deeper discussion of this topic, see our white paper.
Impact of Retirement Eligibility Provisions
We’ve noticed a trend to include nonvested shares (e.g., restricted stock units) in outstanding common shares for basic EPS when such shares are no longer at substantial risk of forfeiture. This follows the logic of ASC 260-10-45-13:
ASC 260-10-45-13: Shares issuable for little or no cash consideration upon the satisfaction of certain conditions (contingently issuable shares) shall be considered outstanding common shares and included in the computation of basic EPS as of the date that all necessary conditions have been satisfied (in essence, when issuance of the shares is no longer contingent).
How does retirement eligibility (RE) play a role here? It depends on the retirement eligibility rule and the nature of awards. Let’s start with awards like RSUs where payout is purely based on the service provided during the vesting period.
One common RE rule is that participants are eligible to receive all unvested shares upon retirement if they’ve reached a certain age and/or provided a certain number of years of service. We refer to this 100% eligibility as “full RE.” Once the employees become retirement eligible, their granted shares have no substantial risk of forfeiture and will be released upon qualifying retirement, even if that happens before the original legal vesting date. In this case, the shares should be included in outstanding common shares for basic EPS rather than proceeding through the treasury stock method for purposes of calculating incremental shares for diluted EPS. If the full RE date was met within the reporting period, then shares would be weighted between basic EPS and the treasury stock method accordingly.
Partial (pro-rata/prorated) RE refers collectively to any another type of RE rule. Unlike full RE, participants only receive a prorated number of shares upon retirement based on the number of months actively employed during the vesting period, or a specific percentage of unvested shares based on age and/or years of service. For RSUs with partial RE rules, only the earned portion will be included in outstanding common shares for basic EPS when employees become retirement eligible. The remainder progress through the treasury stock method.
For awards with contingencies like options and PSUs, payout is still contingent upon performance metrics or stock price movement in the future. Thus, the shares remain in the treasury stock method calculation and are included in diluted EPS until final settlement.
Computation of Year-to-Date EPS
For year-to-date diluted EPS, ASC 260-10-55-3 requires the computation of incremental dilutive shares to be an average of the amounts included in each interim quarterly computation, rather than an independent year-to-date calculation:
ASC 260-10-55-3: The number of incremental shares included in quarterly diluted EPS shall be computed using the average market prices during the three months included in the reporting period. For year-to-date diluted EPS, 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. Example 1 (see paragraph 260-10-55-38) provides an illustration of that provision.
Many companies choose to take a simplified approach by performing an independent year-to-date computation based on the information and assumptions as of the current period. In most cases, the underlying math arrives at the same result as performing the computation based on the average of interim quarters. But the two approaches can lead to different, sometimes even material, results in certain scenarios. Situations that result in different year-to-date dilution calculations include:
- Options that were underwater in one or more quarters but above water on a year-to-date basis (or vice versa)
- Variations in performance payout factors between quarters
- Employee stock purchase plan shares where the average market price in interim periods is lower than enrollment price
- A net loss in an interim quarter with a year-to-date profit (or vice versa)
For any companies using an independent year-to-date calculation with these situations, it’s important to quantify the impact and determine the best approach for the year-to-date disclosure. Naturally, the safest approach is to follow the guidance and compute the year-to-date diluted EPS by weighting the incremental shares from each interim quarter.
Antidilutive Shares Disclosure
Antidilutive shares are required to be disclosed as part of the EPS dilution reporting, per ASC 260-10-50-1(c). Put simply, antidilutive shares are those that are excluded from the diluted EPS computations because including them would be antidilutive. However, the guidance is unclear about the antidilutive share computation for different reporting period, resulting in variations in practice. Let’s start with the two broad interpretations:
- Disclose the weighted average issuable shares that are antidilutive using the treasury stock method
- Disclose the unweighted outstanding shares as of the reporting period end date that are antidilutive using the treasury stock method
We lean toward the second interpretation. By disclosing the unweighted outstanding shares as of the reporting period end date that are antidilutive, all shares that may cause future dilution are captured. Nonetheless, we’ve seen cases where auditors have sided with the first interpretation. Therefore, it’s important to acknowledge that there isn’t a black-and-white answer to determine the antidilutive shares and companies may choose the approach that they prefer.
Choosing between the above two interpretations isn’t the end of the story. Unlike incremental shares, the guidance doesn’t specify how to determine antidilutive shares on a year-to-date basis. Again, practices vary. We’re going to briefly discuss the two most common methods:
- Count shares as antidilutive shares on a year-to-date basis only if they are not dilutive in any interim quarters. The reason is that otherwise, they would have been included in the year-to-date dilutive shares based on quarterly averaging of incremental shares for year-to-date diluted EPS.
- Independently determine antidilutive shares on a year-to-date basis based on the information available as of the reporting period end date. This approach focuses on the forward-looking spirit of the antidilutive shares disclosure.
The second approach may be more straightforward to calculate, and the difference from the first approach may not be material for most cases. However, the second approach could result in certain shares being included for the year-to-date diluted EPS as well as being disclosed as year-to-date antidilutive shares. That will conflict with the concept of antidilutive shares being excluded from the diluted EPS computations.
Again, companies could choose the approach that works better for them and we’ve seen both approaches used widely.
Basic and diluted EPS impact is one of the most complex areas of equity compensation. We just touched on some of the issues here. For instance, we didn’t even cover the impact of modifications, like those that occur in many employee stock purchase plans.
In addition to actual EPS for the period, there’s a strong focus on forecasting future dilution and common shares outstanding in many organizations. Key assumptions for forecasting the EPS impact of stock compensation include the composition of future grants and the size and frequency of settlement events. Of course, there are also stock prices, which themselves can affect other assumptions.
More on the EPS impacts of equity compensation coming from us soon, so stay tuned. In the meantime, please reach out to us if you run into any tricky situations.