ASC 260-10-45-28A through 45-29A describe the application of the treasury stock method to share-based payment awards in the computation of diluted EPS. ASC 260-10-45-29 states, in part:
In applying the treasury stock method described in paragraph 260-10-45-23, the assumed proceeds shall be the sum of all of the following:
a. The amount, if any, the employee must pay upon exercise.
b. The amount of compensation cost attributed to future services and not yet recognized. (This provision applies only to those share-based awards for which compensation cost will be recognized in the financial statements in accordance with Topic 718.)
c. The amount of excess tax benefits, if any, that would be credited to additional paid-in capital assuming exercise of the options. . . . Paragraph 718-740-35-5 states that the amount deductible on an employer’s tax return may be less than the cumulative compensation cost recognized for financial reporting purposes. If the deferred tax asset related to that resulting difference would be deducted from additional paid-in capital (or its equivalent) pursuant to that paragraph assuming exercise of the options, that amount shall be treated as a reduction of assumed proceeds.
The following examples demonstrate the application of the treasury stock method to share-based payment awards in the computation of diluted EPS.
Example 1
Assume the following:
• Company A has net income of $5 million for the year ended December 31, 20X2.
• Company A has 1 million common shares outstanding for the entire year ended December 31, 20X2.
• As of December 31, 20X2, A has 100,000 employee share options outstanding. All the share options were granted on January 1, 20X1, and vest solely on the basis of a service condition. On December 31, 20X1, 50,000 share options vested. The remaining 50,000 share options vest on December 31, 20X2.
• All the share options have an exercise price of $10 per option and a grant-date fair value of $2 per option.
• Company A recognizes the compensation cost for these share options on a straight-line basis over the service period from January 1, 20X1, to December 31, 20X2.
• The average market price of A’s common stock for the year ended December 31, 20X2, was $15 per share.
• Company A’s applicable tax rate is 35 percent.
• For simplicity, the effect of forfeitures has been ignored.
The calculation of diluted EPS is as follows:
Proceeds:
Exercise price (100,000 options × $10 per option) $ 1,000,000 Average unrecognized compensation cost {[unrecognized
compensation cost at beginning of year ($100,000) +
unrecognized compensation cost at end of year ($0)] ÷ 2} 50,000 Excess tax benefit {[($15 average market price – $10 exercise
price) – $2 grant-date fair value] × 100,000 options} × 35% tax
rate 105,000
Total hypothetical proceeds $ 1,155,000
Average market price $ 15
Number of shares reacquired ($1,155,000 hypothetical proceeds ÷
$15 average market price) 77,000
Incremental number of shares issued (100,000 shares issued upon
exercise – 77,000 shares reacquired) 23,000
Weighted-average number of common shares outstanding during
the year — basic 1,000,000
Shares included in diluted EPS computation 1,023,000
Net income available to common shareholders $ 5,000,000
Diluted EPS $ 4.89
Note that in the above computation of diluted EPS, it is assumed that A does not prepare interim financial
statements. ASC 260-10-55-3 states, in part, “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.” For example, assume that when applying the treasury stock method, an entity determined that it must include 10,000 and 15,000 incremental shares in the denominator of diluted EPS for its first and second quarter, respectively. When computing the number of incremental shares to include in the denominator of diluted EPS for the year-to-date six-month period, the entity would weight the 10,000 and 15,000 incremental shares equally. Therefore, 12,500 incremental shares [(10,000 + 15,000) ÷ 2] are included in the denominator of diluted EPS for the year-to-date six-month period.
Example 2
The following example demonstrates the application of the treasury stock method to share-based payment awards when a portion of the awards was exercised during the period. Once the awards are exercised, the shares issued are considered outstanding common shares and are included in the weighted-average number of common shares (i.e., the denominator in the computation of basic EPS). ASC 718-10-45-1 states, in part:
If equity share options or other equity instruments are outstanding for only part of a period, the shares issuable shall be weighted to reflect the portion of the period during which the equity instruments are outstanding.
Assume the same facts as Example 1, except for the following:
• The 50,000 employee share options that vested on December 31, 20X1, were exercised on June 30, 20X2.
The calculation of diluted EPS is as follows:
Weighted-average number of share options outstanding for the
quarter ended December 31, 20X2* 75,000
Proceeds:
Exercise price (75,000 weighted-average share options
outstanding × $10 per option) $ 750,000
Average unrecognized compensation cost: {[unrecognized compensation cost at beginning of year ($100,000) +
unrecognized compensation cost at end of year ($0)] ÷ 2} 50,000 Excess tax benefit {[($15 average market price – $10 exercise
price) – $2 grant-date fair value] × 75,000 options} × 35% tax
rate 78,750
Total hypothetical proceeds $ 878,750
Average market price (year ended December 31, 20X2) $ 15 Number of shares reacquired ($878,750 hypothetical proceeds ÷
$15 average market price) 58,583
Incremental number of shares issued (75,000 shares issued upon
exercise – 58,583 shares reacquired) 16,417
Weighted-average number of common shares outstanding during the year – basic [1 million shares outstanding at the beginning of the year + (50,000 options exercised × 1/2 weighted for half
a year)] 1,025,000
Shares included in diluted EPS computation 1,041,417
Net income available to common shareholders $ 5,000,000
Diluted EPS $ 4.80
* Share options outstanding at the beginning of the year (100,000) plus share options outstanding at the end of year (50,000) divided by two equals the weighted-average number of share options outstanding for the year ended December 31, 20X2. This weighting assumes that exercises occur ratably throughout the year.
Note that in the above computation of diluted EPS, it is assumed that A does not prepare interim financial
statements. ASC 260-10-55-3 states, in part, “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.” For example, assume that when applying the treasury stock method, an entity determined that it must include 10,000 and 15,000 incremental shares in the denominator of diluted EPS for its first and second quarter, respectively. When computing the number of incremental shares to include in the denominator of diluted EPS for the year-to-date six-month period, the entity would weight the 10,000 and 15,000 incremental shares equally. Therefore, 12,500 incremental shares [(10,000 + 15,000) ÷ 2] are included in the denominator of diluted EPS for the year-to-date six-month period.