Issue No Title: Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share

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1 EITF Issue No The views in this summary are not Generally Accepted Accounting Principles until a consensus FASB Emerging Issues Task Force Issue No Title: Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share Document: Issue Summary No. 2, Supplement No. 1 * Date Prepared: October 16, 2003 FASB Staff: Larson (ext. 229) / Sogoloff (ext. 376) Date Previously Discussed: May 15, 2003; July 31, 2003 Previously Distributed EITF Materials: Issue Summary No. 1, dated May 8, 2003; Issue Summary No. 2, dated July 16, 2003 References: FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments (FAS 107) FASB Statement No. 128, Earnings per Share (FAS 128) FASB Statement No. 129, Disclosure of Information about Capital Structure (FAS 129) FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (FAS 150) FASB proposed Statement, Earnings per Share and Disclosure of Information about Capital Structure (Capital Structure ED) APB Opinion No. 15, Earnings per Share (APB 15) AICPA Accounting Interpretations 85, "EPS Treatment of Two-Class and Participating Securities," 86, "Two-Class Method for Nonconvertible Securities, and 87, "Two-Class * The alternative views presented in this Issue Summary Supplement are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination and it is ratified by the Board. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 1

2 Method for Convertible Securities," of APB 15 (AIN 85, AIN 86, and AIN 87, respectively) EITF Issue No. 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios" (Issue 98-5) EITF Issue No , "Application of Issue No to Certain Convertible Instruments" (Issue 00-27) EITF Abstracts, Topic No. D-15, "Earnings-per-Share Presentation for Securities Not Specifically Covered by APB Opinion No. 15" (Topic D-15) EITF Abstracts, Topic No. D-82, "" (Topic D-82) EITF Abstracts, Topic No. D-95, "Effect of Participating Convertible Securities on the Computation of Basic Earnings per Share" (Topic D-95) EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 2

3 Introduction 1. FAS 128 provides guidance on the calculation and disclosure of earnings per share (EPS). FAS 128 defines EPS as "the amount of earnings attributable to each share of common stock" and indicates that the objective of EPS is to measure the performance of an entity over the reporting period. In its deliberations of FAS 128, the Board decided to require the use of the two-class method of computing EPS for those enterprises with participating securities or multiple classes of common stock. 2. Paragraph 60(a) of FAS 128 provides the following description of participating securities: Securities that may participate in dividends with common stocks according to a predetermined formula (for example, two for one) with, at times, an upper limit on the extent of participation (for example, up to, but not beyond, a specified amount per share). Paragraph 61 of FAS 128 adds the following: The if-converted method shall be used for those securities that are convertible into common stock if the effect is dilutive. For those securities that are not convertible into a class of common stock, the "two class" method of computing earnings per share shall be used. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. Under that method: a. Income from continuing operations (or net income) shall be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends (or interest on participating income bonds) that must be paid for the current period (for example, unpaid cumulative dividends). 25 b. The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to each security shall be determined by adding together the amount allocated for dividends and the amount allocated for a participation feature. c. The total earnings allocated to each security shall be divided by the number of outstanding shares of the security to which the earnings are allocated to determine the earnings per share for the security. d. Basic and diluted EPS data shall be presented for each class of common stock. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 3

4 For the diluted EPS computation, outstanding common shares shall include all potential common shares assumed issued. Illustration 6 in Appendix C provides an example of that provision. 25 Dividends declared in the current period do not include dividends declared in respect of prioryear unpaid cumulative dividends. Preferred dividends that are cumulative only if earned are deducted only to the extent that they are earned. 3. Subsequent to the issuance of FAS 128, the FASB staff issued Topic D-95 to address the effect of convertible participating securities on the computation of basic EPS. Topic D-95 clarifies that participating securities that are convertible into common stock should be included in the computation of basic EPS if the effect is dilutive. Topic D-95 states that the determination of how participating convertible securities should be included in the computation of basic EPS (that is, using either the if-converted method or the two-class method) is an accounting policy decision; however, the dilutive effect on basic EPS cannot be less than that which would result from the application of the two-class method that would be required if the same security were not convertible. 4. Consider the following example: Example 1: Company ABC has 10,000 shares of common stock and 5,000 shares of convertible preferred stock outstanding. Each share of preferred stock is convertible into one share of common stock. The preferred stock participates in any dividends on a 1:1 per share ratio with common stock. That is, preferred stock participates in any dividends at a rate that results in an amount that is equivalent to the amount paid to common stock on a per-share basis. Company ABC had net income of $50,000 for 20X3 and paid no dividends during 20X3. Company ABC has an accounting policy that preferred stock will be included in its computation of basic EPS using the if-converted method; as long as the effect on basic EPS is at least as dilutive as that which would result from the application of the two-class method. Basic EPS, before considering the effect of the convertible participating securities, is $5.00 per share. 1 If Company ABC computes basic EPS using the if-converted method, EPS would be 1 Computation of basic EPS excluding the convertible preferred stock: Net Income Available to common shareholders Outstanding shares = Basic EPS $50,000 10,000 shares = $5.00 per share EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 4

5 $3.33 per share. 2 Because the dilutive effect of the convertible preferred stock under the ifconverted method is no less than that which would result from the application of the two-class method ($3.33 per share 3 ), Company ABC would present basic EPS of $3.33 per share. 5. Questions have arisen related to the application of the two-class method as well as its interaction with Topic D-95, in certain circumstances. This Issue Supplement addresses the following issues: Issue 1: Issue 2: Issue 2(a): Whether the two-class method requires the presentation of basic and diluted EPS for all participating securities. How to define a participating security that requires application of paragraph 61 of FAS 128. Whether all potential common shares, that is, securities or other contracts that may entitle their holders to obtain common stock (such as options, warrants, forwards or other contracts to issue common stock), may be participating securities. 2 Computation of basic EPS using if-converted method: Net Income Available to common shareholders Outstanding shares = Basic EPS $50,000 15,000 shares = $3.33 per share Note: Conversion of the preferred stock results in 15,000 shares of common stock outstanding. 3 Computation of basic EPS using two-class method: Undistributed 20X3 earnings = Net income Dividends $50,000 = $50,000 $0 Allocation of undistributed earnings: To common stock: To preferred stock: (10,000) $50,000 = $33,333 (5,000) $50,000 = $16,667 [(5,000) + (10,000)] [(5,000) + (10,000)] $33,333 = $3.33 per share $16,667 = $3.33 per share 10,000 shares 5,000 shares Common Stock Preferred Stock Distributed earnings $0.00 $0.00 Undistributed earnings Totals $3.33 $3.33 EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 5

6 Issue 2(b)(i): Whether dividends or dividend equivalents paid to the holder of a convertible security that are applied to either reduce the conversion price or increase the conversion ratio of the security represent participation rights. Issue 2(b)(ii): Whether an issuing entity should recognize a dividend equivalent that is applied to reduce the conversion price or increase the conversion ratio of a convertible security in its financial statements and, if so, how those dividend equivalents should be recognized in the financial statements. Issue 2(b)(iii): If the Task Force reaches a consensus on View A of Issue 2(b)(i), how convertible securities that participate in dividends via a reduction in the conversion price or an increase in the conversion ratio should be considered by the issuer in the computation of basic EPS. Issue 3: Issue 4: Issue 5: Issue 6: How undistributed earnings should be allocated to a participating security. Whether an entity that allocated undistributed earnings to a non-convertible participating security would continue to do so in a period of net loss if the effect is anti-dilutive. Whether a convertible participating security would be excluded from the computation of basic EPS if an entity has a net loss from continuing operations. How a convertible participating security is included in the computation of diluted EPS. 6. In preparing this Issue Supplement, the FASB staff has summarized the discussions of the Task Force on the issues that were discussed at the July 31, 2003 EITF meeting. In addition, the FASB staff has further developed Issues 2(b)(i), 2(b)(ii), 2(b)(iii), 5, and 6 for initial discussion at the November 12-13, 2003 EITF meeting. The FASB staff recommends that the Task Force first consider the issues discussed at the previous meeting, before beginning discussions of the remaining open issues at the November meeting, as conclusions to be reached on the issues previously discussed may impact the outcome of issues 2(b)(i), 2(b)(ii), 2(b)(iii), 5, and 6. Accordingly, to facilitate discussion of the issues in the appropriate order, the issues in this Issue Supplement are not presented in numerical order but, rather, have been sequenced in the order that the FASB staff believes they should be discussed at the November meeting. 7. The FASB staff believes that in order to achieve the Board's stated goal of simplification and codification, the consensuses reached in this Issue and the staff announcement contained in EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 6

7 Topic D-95 should be codified into one EITF Issue. Accounting Issues and Alternatives Issue 1: Whether the two-class method requires the presentation of basic and diluted EPS for all participating securities. 8. At the July 31, 2003 EITF meeting, the Task Force reached a tentative conclusion on Issue 1 that the two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise would have been available to common shareholders, but does not require the presentation of basic and diluted EPS for securities other than common stock. However, the Task Force observed that the presentation of basic and diluted EPS for a participating security other than common stock is not precluded. Issue 2: How to define a participating security that requires application of paragraph 61 of FAS At the July 31, 2003 EITF meeting, the Task Force reached a tentative conclusion on Issue 2 that, for purposes of applying paragraphs 60 and 61 of FAS 128, a participating security is a security that may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not. The Task Force observed that the form of such participation does not have to be a dividend that is, any form of participation in undistributed earnings may constitute participation by that security, regardless of whether the payment to the security holder was referred to as a dividend. Issue 3: How undistributed earnings should be allocated to a participating security. 10. At the July 31, 2003 EITF meeting, the Task Force discussed but was not asked to reach a consensus on Issue 3. However, the Task Force generally preferred the view that undistributed earnings for a period should be allocated to a participating security based on the contractual participation rights of the security to share in those current earnings. If the terms of a security do not specify objectively determinable, nondiscretionary participation rights, then undistributed EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 7

8 earnings would not be allocated based on arbitrary assumptions. Also, if an entity could avoid distributions of undistributed earnings to participating security holders, then no allocation of that period's earnings to the participating security would be made. Participation rights that are contingent on or subject to the discretion of the company should be fully disclosed in accordance with paragraph 4 of FAS The FASB staff recommends that the Task Force consider reaching a consensus based upon the preferred view as expressed at the July meeting. To facilitate further discussion of this issue, the FASB staff has applied the preferred view put forward at the July meeting to the following examples (Note: In all the examples set forth below, the participation rights of the securities would be required to be disclosed in accordance with the provisions of FAS 129, regardless of whether or not undistributed earnings are allocated to the participating security): Example 3: A participating security that provides the holder with the ability to participate in all dividends declared with the holders of common stock on a 1:1 per-share basis. Evaluation: The undistributed Earnings should be allocated between the common stock and the participating security on a 1:1 per-share basis. Example 4: A participating security that provides the holder with the ability to participate with the holders of common stock in dividends declared contingent upon the occurrence of a specified event that is not objectively determinable (for example, management discretion or liquidation). Evaluation: The terms of the participating security in this scenario do not specify objectively determinable, nondiscretionary participation rights; therefore, undistributed earnings would not be allocated to the participating security. The participation rights would be required to be disclosed in accordance with the provisions of FAS 129. Example 5: A participating security that provides the holder with the ability to participate with the holders of common stock in earnings for a period in which a specified event occurs, regardless of whether a dividend is paid during the period (for example, achievement of a target market price of a security or achievement of a certain earnings level). Evaluation: Undistributed earnings would be allocated to common stock and the participating securities based on the assumption that all of the earnings for the period are distributed. Undistributed earnings would be allocated to the participating security if the EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 8

9 contingent condition would have been satisfied at the reporting date, irrespective of whether or not an actual distribution was made for the period. Example 6: A participating security that provides the holder with the ability to participate in extraordinary dividends. The classification of dividends as extraordinary is predetermined by a formula, for example, any dividend per common share in excess of five percent of the current market price of the stock is defined as extraordinary. Evaluation: Undistributed earnings would be allocated to common stock and the participating securities based upon the assumption that all of the earnings for the period are distributed. If earnings for a given period exceed the specified threshold above which the participating security would participate (that is, earnings for the period are in excess of five percent of the current market price of the stock), undistributed earnings would be allocated to the participating security according to its terms. Example 7: A participating security that provides the holder with the ability to participate in extraordinary dividends. The classification of dividends as extraordinary is within the sole discretion of the Board of Directors. Evaluation: Undistributed earnings would be allocated only to common stock. Since the classification of dividends as extraordinary is within the sole discretion of the Board of Directors, undistributed earnings would not be allocated to the participating security as the participation in the undistributed earnings would not be objectively determinable. Example 8: A participating security that provides the holder with the ability to participate in all dividends up to a specified threshold. For example, the security participates in dividends per common share up to five percent of the current market price of the stock. Evaluation: Undistributed earnings would be allocated to common stock and the participating securities based upon the assumption that all of the earnings for the period are distributed. In this example, undistributed earnings would be allocated to common stock and to the participating security up to 5 percent of the current market price of the common stock, as the amount of the threshold for participation by the participating security is objectively determinable. The remaining undistributed earnings for the period would be allocated to common stock. 12. Some members of this Issue's Advisory Group and members of the FASB staff raised concerns regarding the application of the generally preferred view expressed in paragraph 10, above. Specifically, those concerns relate to the application of the criteria for allocation of undistributed earnings consistently to both perpetual participating securities and participating securities that have stated maturities. To highlight this issue, consider the fact that the view EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 9

10 expressed in paragraph 10 would not provide for the allocation of undistributed earnings to a participating security with a stated maturity that has the contractual right to share in ordinary dividends on a 1:1 basis with common stockholders. This conclusion is reached because the issuer could avoid allocating earnings to the participating security simply by not paying dividends to the common stockholders during the period in which the participating security in question remains outstanding. While the preferred view expressed in paragraph 10 was applied to the above examples, the FASB staff did not take this complicating factor into consideration as it would like further clarification of the preferred view from the Task Force. Issue 4: Whether an entity that allocated undistributed earnings to a non-convertible participating security, would continue to do so in a period of net loss even though the effect is anti-dilutive. 13. At the July 31, 2003 EITF meeting, the Task Force reached a tentative conclusion on Issue 4 that an entity would continue to allocate undistributed earnings/losses to a nonconvertible participating security in periods of net loss even if the effect is antidilutive. The Task Force observed that losses that reduce the undistributed earnings in which a participating security has a right to share should be allocated to that participating security. FASB Staff Commentary: If a consensus if reached on Issue 4, determination of whether losses should be allocated to a non-convertible participating security should be consistent with any consensus reached on Issue 3, above. The FASB staff believes that losses should be allocated to a participating security only if the contractual terms of the security provide for the participating security to share in the current losses of the issuer with common stockholders on a basis that is objectively determinable. In other words, the participating security must have the right to participate the entity's earnings and the obligation to share in its losses (that is, share in the residual net assets of the issuing entity) in order for losses to be allocated to a participating security. Issue 5: Whether a convertible participating security would be excluded from the computation of basic EPS if an entity has a net loss from continuing operations. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 10

11 14. The following example facilitates discussion of this issue. Example 9: Company ABC has 10,000 shares of common stock and 5,000 shares of convertible preferred stock outstanding. Each share of preferred stock is convertible into one share of common stock. The preferred stock participates in any dividends on a 1:1 per share ratio with common stock. That is, preferred stock participates in any dividends at an equal rate of the amount paid to common stock on a per-share basis. Company ABC had a net loss of ($50,000) for 20X3 and paid no dividends during 20X3. Pursuant to Topic D-95, Company ABC has an accounting policy that participating preferred stock will be included in the computation of basic EPS using the if-converted method, although, the dilutive effect on basic EPS cannot be less than that which would result from the application of the twoclass method if the security were not convertible. View A: The effect of the convertible participating security would be excluded from the computation of basic EPS as it is anti-dilutive under either the two-class or the if-converted method. 15. Proponents of View A believe that paragraph 13 of FAS 128 clearly is intended to prohibit an entity from including a security in the computation of EPS that will have an anti-dilutive effect. Those proponents point to paragraph 13 which states "the computation of diluted EPS shall not assume conversion, exercise, or contingent issuance of securities that would have an antidilutive effect on earnings per share." While that paragraph relates specifically to diluted EPS, supporters of View A believe this same concept should also be applied in computing basic EPS relative to participating securities. 16. Proponents of View A believe that in situations in which an entity has a net loss, allocating a portion of those losses to a convertible participating security would be anti-dilutive (whether in the calculation of basic or diluted EPS). Accordingly, proponents of View A do not believe that convertible participating securities should be included in the computation of basic EPS if an entity has a net loss from continuing operations, as the effect of the participating security would be anti-dilutive. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 11

12 17. Proponents of View A believe that in Example 7, above, Company ABC would compute basic EPS without including the effect of the convertible participating securities (loss of $5.00 per share 4 ) as its effect would be anti-dilutive (loss of $3.33 per share if included under the ifconverted method). View B: The effect of the convertible participating security would not be included in the computation of basic EPS if it is anti-dilutive. However, the effect of excluding the convertible participating security from basic EPS cannot result in basic EPS that is less diluted than that which would result under application of the two class method if the same security were not convertible. 18. Proponents of View B agree with proponents of View A; however, they note that the concept behind Topic D-95 was that a convertible participating security should have an impact on basic EPS that is at least as dilutive as that which would result if the same participating security was not convertible. Proponents of View B believe that a similar qualification should apply in periods of net loss, that is, if the effect of not including the convertible participating security in the computation of basic EPS is a less dilutive result than that which would occur from the application of the two-class method if the same security were not convertible, use of the two-class method to include the convertible participating security in basic EPS should be required. 19. Proponents of View B believe that in Example 7, above, Company ABC would compute basic EPS without including the effect of the convertible participating securities (loss of $5.00 per share 5 ) as their effect is anti-dilutive. Company ABC would not include the effect of the 4 Computation of basic EPS excluding the convertible preferred stock: Net loss attributable to common shareholders Outstanding shares = Basic EPS ($50,000) 10,000 shares = ($5.00) Loss per share 5 Computation of basic EPS excluding the convertible preferred stock: Net loss attributable to common shareholders Outstanding shares = Basic EPS ($50,000) 10,000 shares = ($5.00) Loss per share EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 12

13 convertible participating security using the if-converted method (loss of $3.33 per share 6 ), as the effect is anti-dilutive. Likewise, the dilutive effect of not including the convertible participating securities in the computation of basic EPS is not less than that which would result from the application of the two-class method if the preferred stock were not convertible (loss of $3.33 per share 7 ). It should be noted that EPS under both the if-converted and the two-class methods is the same in this example because the preferred stockholders' share in the undistributed earnings on the same basis as the common stockholders; that is, on a 1:1 ratio. Under circumstances in which this relationship is not 1:1, EPS under the if-converted and two-class methods would not be equal. 20. Proponents of View B concede however that the above question is more academic than it is practical as the two-class method would only result in a more dilutive answer if income had to be allocated to the participating security, which, in turn, increased the net loss attributable to the common shareholders. FASB Staff Commentary: The Issue being addressed in Issue 5 is fundamentally the same as the issue addressed by the Task Force in Issue 4 of this Issue Supplement. The Task Force previously reached a tentative conclusion on Issue 4 that an entity would continue to allocate undistributed losses to a nonconvertible participating security in periods of net loss even if the effect is antidilutive. The FASB staff recommends that the Task Force view this issue in the same light and reach a similar 6 Computation of basic EPS using if-converted method: Net loss attributable to common shareholders plus preferred stock dividends Outstanding shares plus the impact of assumed conversions = Basic EPS ($50,000 + $0) (10, ,000) shares = ($3.33) Loss per share The conversion of 5,000 shares of preferred stock would not be assumed as it is anti-dilutive. 7 Computation of basic EPS using two-class method: Allocation of net loss attributable: To common stock: To preferred stock: (10,000) ($50,000) = ($33,333) (5,000) ($50,000) = ($16,667) [(5,000) + (10,000)] [(5,000) + (10,000)] ($33,333) = ($3.33) Loss per share ($16,667) = ($3.33) Loss per share 10,000 shares 5,000 shares EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 13

14 conclusion as in Issue 4, irrespective of the differences that may exist between securities that are convertible into common stock of the issuer and those that are not. In any event, the FASB staff believes that the model developed to allocate "undistributed" losses to participating securities should be applied consistently to both non-convertible and convertible securities. Issue 2(a): Whether all potential common shares, that is, securities or other contracts that may entitle their holders to obtain common stock (such as options, warrants, forwards, or other contracts to issue common stock), may be participating securities. 21. At the July 31, 2003 EITF meeting, the Task Force discussed but was not asked to reach a consensus on Issue 2(a). Some Task Force members noted a preference for the view that a potential common share that has a current right to participate in earnings would be a participating security and that basic and diluted EPS should be calculated as the more dilutive of the two-class method or the method prescribed by FAS 128 or related authoritative guidance (for example, the treasury stock method or the reverse treasury stock method). The Task Force asked the FASB staff to further explore Issue 2(a) with the Advisory Group and prepare examples for discussion at a future meeting. FASB Staff View: Paragraph 21 summarizes the discussions undertaken by the Task Force relative to Issue 2(a) at the July meeting. The FASB staff has considered those discussions and recommends that the Task Force further consider whether or not the securities in question represent participating securities if the potential common share has a current contractual right to participate in earnings. The underlying issue of Issue 2(a) is the determination of how such securities should be considered in basic EPS if those securities are considered participating securities. The FASB staff believes that considering the inclusion of participating securities in the computation of basic EPS using the treasury stock or reverse treasury stock method is inconsistent with the guidance provided in FAS 128 with respect to the computation of basic EPS. The FASB staff further believes that the only provision in FAS 128 for dealing with participating securities in basic EPS that are not convertible into common stock, is the two-class method; Topic D-95, in limited circumstances, permits the use of the if-converted method. One issue that is currently not EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 14

15 addressed, and potentially should be considered, is whether dividends paid to holders of common stock equivalents should be considered as a reduction to income available to common stockholders in the computation of basic EPS. The FASB staff recommends that the Task Force consider whether this is an issue that should be addressed within the scope of Issue Issue 2(b)(i): Whether dividends or dividend equivalents paid to the holder of a convertible security in the form of a reduction to the conversion price or an increase in the conversion ratio of the security represent participation rights. 8 Background: 22. For purposes of this Issue Supplement a dividend equivalent is assumed to be any adjustment to the conversion price or conversion ratio of a convertible security that is tied to the declaration of a dividend by the issuing entity. 23. In some cases, an issuer may provide the holder of a convertible security with a feature that either reduces the conversion price or increases the conversion ratio of the security to reflect the amount of dividends paid by the issuer to common stockholders. Some refer to such a feature as dividend protection. This feature adjusts the conversion price downward or the conversion ratio upward to compensate the holder for dividends paid on the underlying stock that the security holder does not receive in cash. 24. As the fair value of a share of stock is, in concept, equal to the present value of all future dividends, each dividend paid by the issuer lowers the fair value of the stock. Some consider these dividend protection features to be similar to anti-dilution provisions that may be incorporated into a security to protect the holder in the event of an equity restructuring or the declaration of stock dividends, while others believe that value is being transferred to the convertible security holder. Although, in general, the accounting for a cash dividend paid directly to the holder of a participating security is clear, questions persist regarding the 8 For purposes of facilitating discussion of this issue, the FASB staff has framed this issue in the context of a convertible security. The FASB staff would expect that a consensus reached on this issue would apply similarly to options, warrants, forwards, or other contracts to issue an entity s common stock if these securities provide for an adjustment to the exercise price or ratio that is tied to the declaration of dividends by the issuer. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 15

16 accounting for dividend equivalents provided in the form of a reduction to the conversion price or an increase in the conversion ratio of a convertible security. As a result of the accounting for these dividend equivalents being unclear, the determination of whether or not the securities in question have participation rights, and thus should be considered participating securities for purposes of computing basic EPS, is also unclear. 25. The following example is intended to facilitate discussion of this Issue. Example 2: Company XYZ's stock is trading at $100 per share on the date that Company XYZ issues 1, year convertible bonds, with an aggregate par value of $1,000,000. The bonds have the following features: Each bond is convertible into 8 shares (8,000 in the aggregate) of common stock (conversion price is $125 or a 25 percent conversion premium assuming the stock is trading at $100), The bonds are convertible at the option of the holder any time prior to maturity. The conversion price is adjusted for typical antidilution provisions (such as stock splits, stock dividends, and so forth), and is also decreased for any extraordinary dividends paid to common stockholders. The conversion price is reduced for extraordinary dividends paid to common stockholders on a dollar for dollar basis (that is, a $1.00 per share extraordinary dividend would reduce the conversion price by $1.00 per share 9 ). Extraordinary dividends are defined in the bylaws of the corporation, which state that "in addition to extraordinary dividends specifically declared and paid to common stockholders, extraordinary dividends are deemed to be dividends in excess of $2.50 per share during a fiscal year. Bondholders share in extraordinary dividends with common shareholders through a reduction to the conversion price that is intended to compensate the holder equally for the cash dividend paid to the common shareholders. The amount of the adjustment for the bondholders is determined based upon the number of shares into which the bonds are convertible at any given point in time." Coupon rate is 3.5 percent (paid semi-annually). The bondholders do not have any voting rights prior to conversion. View A: Yes. Dividend equivalents in the form of a reduction to the conversion price or an increase in the conversion ratio of a convertible security represent participation rights. 9 This assumption is used in this example for simplicity purposes, as in practice the conversion price will generally not be reduced by the amount of the dividend. Rather, the conversion rate within the security is typically adjusted to equalize the value of the underlying shares before and after the dividend is declared. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 16

17 26. Proponents of View A believe that dividend equivalents provided to the holder of a convertible security in the form of either a reduction to the conversion price or an increase in the conversion ratio of the convertible security represent participation rights and, therefore, should be treated in a manner similar to cash dividends paid to a convertible security holder. 27. Proponents of View A believe that there is no difference between dividends paid directly to the holder of a convertible participating security and dividend equivalents that are applied to either reduce the conversion price or increase the conversion ratio of a convertible security. View A supporters believe that in both cases, the security holders have received value, have participated in earnings, and, by the terms of the security, have the right to participate in earnings. 28. Proponents of View A believe that value has been transferred to the holder of the convertible security because the reduction in the conversion price or increase in the conversion ratio puts the holder in a more favorable economic position as compared to prior to the adjustment to the conversion price since the value of the convertible security increases each time the conversion price is reduced or the conversation ratio is increased. Accordingly, supporters of View A conclude that the security in Example 2 is a participating security and that this security should be considered in the computation of basic EPS by the issuing entity. 29. Proponents of View A further point out that this conclusion is consistent with Topic D-82, which states: Paragraph 171 of Statement 128 defines income available to common stockholders as "income (or loss) from continuing operations or net income (or net loss) adjusted for preferred stock dividends." The FASB staff believes that an adjustment to net income or loss for preferred stock dividends is required in accordance with the provisions in paragraph 9 of Statement 128 for all preferred stock dividends, regardless of the form of payment. [Emphasis added.] View B: No. Dividend equivalents in the form of a reduction to the conversion price or an increase in the conversion ratio of a convertible security do not represent participation rights. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 17

18 30. Proponents of View B believe that dividend equivalents that are applied to either reduce the conversion price or increase the conversion ratio of a convertible security represent, at most, antidilution features rather than participation rights. Proponents of View B believe that there is a distinction between dividends that are paid and those that are applied to either reduce the conversion price or increase the conversion ratio of a convertible security. Reductions to the conversion price are merely contingent transfers of value to the convertible security holders to equalize the conversion value of the security before and after the payment of the dividend on the underlying common stock. 31. Proponents of View B believe that because the holder will realize the value provided by the application of a dividend equivalent to the conversion price or conversion ratio of a convertible security only if the holder converts (absent selling the bonds on the open market), no value is transferred to the holder at the time the dividend equivalent is declared. 32. View B supporters believe that dividend equivalents applied to adjust the conversion price or conversion ratio do not change the value of the convertible security, but merely maintain the holder's value relative to the effect of the dividend on the fair value of the underlying common stock. Since the value of the convertible security has not changed, View B supporters believe that no value is transferred to the holder. 33. Accordingly, proponents of View B believe that dividend equivalents in the form of a reduction to the conversion price or an increase in the conversion ratio of a convertible security do not represent participation rights. Rather, they are a form of anti-dilution feature that should be disclosed as part of an instrument's conversion terms in accordance with paragraph 4 of FAS 129, but not as a participation right. 34. Proponents of View B further point out that the participation in undistributed earnings for the types of securities in question is dependent upon the current conversion price of the convertible security. That is, each time the security participates through a reduction in the conversion price, the participation feature has the effect of increasing the allocation of earnings EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 18

19 to the participating security, thereby making an allocation of undistributed earnings to a security that participates in this fashion inoperable. View B supporters believe that this anomaly highlights a potential flaw in a consensus that securities, which include a feature that adjusts the conversion price or conversion ratio based on dividends declared, are participating securities and therefore potentially require use of the two-class method in computing basic EPS. 35. Under this View, the security in Example 2 would not be a participating security and would have no effect on basic EPS of the issuing entity. Issue 2(b)(ii): Whether an issuing entity should recognize a dividend equivalent that is applied to reduce the conversion price or increase the conversion ratio of a convertible security in its financial statements and, if so, how those dividend equivalents should be recognized in the financial statements. 10 View A: Yes, the issuing entity should recognize a dividend equivalent that is applied to reduce the conversion price or increase the conversion ratio of a convertible security in its financial statements and the dividend should be treated as a contingent beneficial conversion feature under Issue 98-5 and Issue Proponents of View A believe that the application of a dividend equivalent to reduce the conversion price of a convertible security represents a contingent beneficial conversion feature that should be recognized under Issue 98-5 and Issue 00-27, if the criteria for recognition are met. Because the issuer does not know the number of shares that would be received upon conversion of the security at the commitment date, it would specifically recognize the beneficial conversion feature in accordance with Issue 7 of Issue Under Issue 7, the issuing entity would only recognize the beneficial conversion feature once the conversion price is adjusted below the commitment date stock price. If adjustments to the conversion price never result in a conversion price that is below the commitment date stock price, the dividend equivalents applied 10 The FASB staff believes that this question should be addressed irrespective of the consensus reached on Issue 2(b)(i). If it is determined that the security in question is not a participating security, the FASB staff believes that if the value of a dividend equivalent is recognized as a dividend within stockholder s equity, that value should be reflected as a reduction to income available to common stockholder s in computing basic EPS. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 19

20 to reduce the conversion price or increase the conversion ratio would not be recognized in the financial statements of the issuing entity. 37. Consider the security in Example 2, above, and assume further that Company XYZ declares an extraordinary dividend of $1.00 per common share during the reporting period. Under View A, application of that dividend equivalent to decrease the conversion price of the convertible bonds, by $1 from $125 to $124, would not be recognized in the financial statements of the issuer as the conversion option remains above the commitment date stock price of $100. View B: Yes, the issuing entity should recognize a dividend equivalent that is applied to reduce the conversion price or increase the conversion ratio of a convertible security in its financial statements and the amount to be recognized should be based on the difference in the fair value of the convertible security before and after the change in the conversion price or conversion ratio. 38. Proponents of View B believe that the issuing entity should recognize a dividend equivalent in its financial statements because the issuing entity has transferred value to the convertible security holder and the sacrifice of this value should be recognized by the issuer. 39. Proponents of View B (as well as proponents of Views C and D) acknowledge that under the guidance in Issues 98-5 and 00-27, the issuer of a convertible security that provides dividend equivalents that reduce the conversion price or increase the conversion ratio of the security must consider, at issuance, whether a convertible security has a beneficial conversion feature. Assuming that a beneficial conversion feature does not exist within the terms of the security at the commitment date, proponents of View A believe that dividend equivalents provided subsequent to that initial determination are outside of the scope of Issues 98-5 and Proponents of View B believe that the most representationally faithful way to measure the value transferred by a dividend equivalent is by determining the difference in the fair value of the convertible security before and after the change in the conversion price or conversion ratio. Proponents of View B believe that the issuer would recognize a reduction in retained earnings, with an offsetting increase in additional paid in capital, in the period the dividend is declared. If EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 20

21 no change in the fair value of the security results from the application of the dividend equivalent to the conversion price or conversion ratio, no dividend should be recognized. 41. Consider the security in Example 2, above, and assume further that Company XYZ declares an extraordinary dividend of $1.00 per common share during the reporting period. Under View B, application of that dividend equivalent to decrease the conversion price of the convertible bonds, by $1 from $125 to $124, has the effect of increasing the fair value of the bonds by $5,000. Proponents of View B believe that the issuing entity should recognize the $5,000 change in the fair value of the bonds upon declaration of the extraordinary dividend, by reducing retained earnings by $5,000 and recognizing a corresponding increase in additional paid-in capital. View C: Yes, the issuing entity should recognize a dividend equivalent that reduces the conversion price or increases the conversion ratio of a convertible security in its financial statements and the amount to be recognized should be based upon the change in the intrinsic value of the conversion feature embedded in the convertible security. 42. Proponents of View C believe that the issuing entity should recognize a dividend equivalent that is applied to reduce the conversion price or increase the conversion ratio of a convertible security in its financial statements for the same reasons as discussed above under View B. Furthermore, proponents of View C agree with View B proponents that the dividend equivalent should be recognized in the financial statements by reducing retained earnings for the value of the dividend equivalent, with a corresponding increase in additional paid in capital. However, View C supporters believe that the value transferred by the issuing entity to the holders of the convertible security should be measured by the resulting change in the positive or negative intrinsic value of the conversion feature embedded in the convertible security. For purposes of this Issue Supplement, negative intrinsic value represents the extent to which the conversion option of the convertible security is out of the money. 43. Proponents of View C believe that a dividend equivalent that adjusts the conversion price of a convertible security is similar to a beneficial conversion feature. Accordingly, these EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 21

22 proponents believe that the value of the dividend equivalent should be based on the intrinsic value of the conversion feature, consistent with the measurement of beneficial conversion features under Issues 98-5 and While supporters of View C may concede that a fair value model as described in View B may be more conceptually sound, the fair value model would be tantamount to measuring subsequent changes in the fair value of an embedded conversion feature when the conversion feature, under existing GAAP, is not separately recognized. 44. Consider the security in Example 2, above, and assume further that Company XYZ declares an extraordinary dividend of $1.00 per common share during the reporting period. Under View C, application of the dividend equivalent to reduce the conversion price of the bonds results in the bonds being convertible into 8,065 shares of XYZ's common stock at the adjusted conversion price of $124. Proponents of View B believe that the decrease in negative intrinsic value [(10,000 8,000) (10,000 8,065) = 65 $100/sh. = $6,500] represents the value transferred to the holder of the convertible security. View B proponents believe that this amount should be recognized as a dividend in the issuer's financial statements in the same manner as described in View B, above. View D: Yes, the issuing entity should recognize a dividend equivalent that reduces the conversion price or increases the conversion ratio of a convertible security in its financial statements; however, it should only be recognized to the extent that the conversion feature of the convertible bond has positive intrinsic value resulting from the reduction in the conversion price or increase in the conversion ratio. 45. Proponents of View D believe that the issuing entity should recognize a dividend equivalent that reduces the conversion price or increases the conversion ratio of a convertible security in its financial statements for the same reasons discussed above under View B. Furthermore, proponents of View D agree with View B and View C proponents that the dividend equivalent should be recognized in the financial statements by reducing retained earnings for the value of the dividend, with a corresponding increase in additional paid in capital. However, View D supporters believe that not all reductions in the conversion price or increases in the conversion ratio result in measurable value being transferred to the holder of the convertible security. EITF Issue No Issue Summary No. 2, Supplement No. 1, p. 22