Update to ASC 718: Diluted EPS

The FASB's update to ASC 718 is a gift that keeps on giving, at least in terms of blog entries. Today I discuss something many of you may not have considered: the impact the update will have on the calculation of common equivalents under the Treasury Stock Method.

EPS: A Story of a Numerator and a Denominator

Earnings per share simply allocates a company's earnings to each share of stock.  It is calculated by dividing earnings (the numerator) by the number of shares common stock outstanding (the denominator).  Public companies report two EPS figures: Basic EPS and Diluted EPS. In Diluted EPS, the denominator is increased for any shares that the company could be contractually obligated to issue at some point in the future, such as shares underlying stock options and awards.  These arrangements are referred to as "common equivalents."

A Quick Refresher on the Treasury Stock Method

The Treasury Stock Method is used to determine how many shares should be included in the denominator of Diluted EPS for all of the arrangements that could obligate the company to issue shares in the future.  Under the Treasury Stock Method, companies assume that all of these arrangements are settled (regardless of vesting status), the underlying shares are issued, and any proceeds associated with the settlement are used to repurchase the company's stock. The net shares that would be issued after taking into account the hypothetical repurchases increase the denominator in the EPS calculation.

The possible sources of settlement proceeds include any amount paid for the stock, any windfall tax savings ("windfall" is the operative word here), and any unamortized expense. For a more detailed explanation, see the chapter "Earnings Per Share" in Accounting for Equity Compensation in the United States.

What the Heck are "Windfall" Tax Savings?

"Windfall" tax savings are those that increase paid-in capital rather than decreasing tax expense.  Normally, tax savings result from expenses and reduce the company's tax expense.  But this isn't always the case with the tax savings from stock compensation. Sometimes the company's tax deduction is greater than that expense recognized for an award. Currently when that occurs, the tax savings resulting from any deduction in excess of the expense simply increases paid-in capital; this savings doesn't reduce tax expense.

How Does the Update to ASC 718 Change This?

Any windfall tax savings have to be accounted for somewhere in the EPS calculation. Right now, because these savings don't impact tax expense or earnings, and thus aren't reflected in the numerator of the EPS equation, they are treated as a source of settlement proceeds and reduce the denominator.

Once the update goes into effect, this is all changed. All tax savings, windfall or otherwise, will reduce tax expense and increase earnings, which means these savings will be reflected in the numerator for EPS. Because the savings will be reflected in the numerator, they will no longer be treated as a source of settlement proceeds under the Treasury Stock Method.

You Have to Admit, It Does Simply Things

The upshot is that, once a company has adopted the update to ASC 718, the settlement proceeds when applying the Treasury Stock Method to awards will be limited to just two sources: the purchase price and any amortized expense.  Windfall tax benefits will be eliminated as a source of proceeds.