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 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 * Date Prepared: July 16, 2003 FASB Staff: Degano (ext. 337) / Martin (ext. 342) Date Previously Discussed: None Previously Distributed EITF Materials: Issue Summary No. 1 References: FASB Statement No. 128, Earnings per Share (FAS 128) FASB Statement No. 129, Disclosure of Information about Capital Structure (FAS 129) FASB Statement No. 107, Disclosure about Fair Value of Financial Instruments (FAS 107) 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 Method for Convertible Securities," of APB 15 (AIN 85, AIN 86, and AIN 87, respectively) 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-95, "Effect of Participating Convertible Securities on the * The alternative views presented in this Issue Summary 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, p. 1

2 Computation of Basic Earnings per Share" (Topic D-95) EITF Issue No Issue Summary No. 2, 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. EITF Issue No Issue Summary No. 2, p. 3

4 d. Basic and diluted EPS data shall be presented for each class of common stock. 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 participating convertible securities on the computation of basic EPS. Topic D-95 clarifies that participating securities that are convertible into common stock 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; although, the dilutive effect on basic EPS cannot be less than that which would result from the application of the two-class method if the security were not convertible. EITF Issue No Issue Summary No. 2, p. 4

5 Company ABC could not compute basic EPS without including the convertible participating securities ($5.00 per share 1 ) as the effect of the convertible preferred stock is dilutive. Instead, Company ABC would compute basic EPS using the if-converted method ($3.33 per share 2 ), as the dilutive effect that would result from including the effect of the convertible preferred stock under the if-converted method is no less than that which would result from the application of the two-class method if the preferred stock were not convertible ($3.33 per share 3 ). 5. Questions related to the application of the two-class method and, including its interaction with Topic D-95, have arisen. This Issue Summary addresses the following issues: Issue 1: Whether the two-class method requires the presentation of basic and diluted EPS for all participating securities. Issue 1(a): If the two-class method does not require the presentation of basic and diluted EPS for all participating securities, when is the presentation of basic and diluted EPS appropriate. 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 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, p. 5

6 Issue 2: How to define a participating security that requires application of paragraph 61 of FAS 128. Issue 2(a): Issue 2(b): 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, convertible debt, and convertible preferred stock), may be participating securities. Whether dividends or dividend equivalents paid to the holder of a convertible participating security that are applied to either reduce the conversion price or increase the conversion ratio of the security represent participation rights. 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 second Issue Summary, the FASB staff organized an Advisory Group to understand the issues and discuss common examples of participating securities. The Advisory Group noted that in Issue Summary No. 1, the FASB staff used the phrase "two-class method" interchangeably with a requirement to present basic and diluted EPS while presuming that all participating securities require either (a) an adjustment to earnings available to common shareholders (the numerator of the earnings per share calculation) when the participation is "earned," that is, the dividend was either declared or the undistributed earnings could not be distributed without paying the earned amount to the holders of the participating security, or (b) disclosure in accordance with paragraph 4 of FAS 129. The Advisory Group suggested that such an approach may be confusing. In order to avoid any confusion, the FASB staff has prepared this revised Issue Summary for discussion at the July 31, 2003 EITF 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 Topic D-95, should be codified into one EITF Issue. EITF Issue No Issue Summary No. 2, p. 6

7 Accounting Issues and Alternatives Issue 1: Whether the two-class method requires the presentation of basic and diluted EPS for all participating securities. View A: Yes. The two-class method is an earnings allocation formula that treats a participating security as another class of common stock with a dividend rate different from the dividend rate on the issued common stock and requires an entity to present both basic and diluted EPS for that participating security. 8. Proponents of View A believe that the two-class method is an earnings allocation formula that treats a participating security as another class of common stock with a dividend rate different from the dividend rate on the issued common stock, and requires an entity to present both basic and diluted EPS for that participating security. Those proponents point to paragraph 61 of FAS 128, which states, in part: 61. 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 c. The total earnings allocated to each security [common stock and the participating 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. [Emphasis added.] 9. Proponents of View A believe that the two-class method treats a participating security as though it were another class of common stock. Under such an approach, all participating securities require either that earnings be attributed to the participating security or that the participation rights are disclosed under paragraph 4 of FAS 129 and that both basic and diluted EITF Issue No Issue Summary No. 2, p. 7

8 EPS is presented. Proponents of View A believe that the use of the term "common stock" in paragraph 61(d) was merely an oversight. Those proponents believe the term common stock was inadvertently used but is consistent with assumption that the participating security is treated as though it were another class of common stock with a different dividend rate. Proponents of View A find it hard to reconcile the fact that the Board provided the computational guidance provided in paragraph 61(c), which specifically shows how to calculate EPS for the participating security, if the Board did not expect that basic and diluted EPS would be presented for a participating security. View B: No. The two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise have been available to common shareholders; however, the presentation of basic and diluted EPS is only required for the issued common stock. 10. Proponents of View B believe that although the two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise have been available only to common shareholders, the presentation of basic and diluted EPS is only required for the issued common stock. Proponents of View B believe that this is explicitly clear in FAS 128 and point to paragraph 61(d) of FAS 128, which clearly states that "basic and diluted EPS data shall be presented for each class of common stock (emphasis added)." 11. Proponents of View B believe that this is not a drafting oversight but, rather, intentional wording, as the Board only intended to require presentation of EPS data for the issued common stock since some participating securities, for example convertible debt, do not lend themselves to an EPS presentation, as there are no shares to use for the denominator. Proponents of View B believe that the computational guidance contained in paragraph 61(c) is presented to provide assistance in those instances in which an entity decides that it is appropriate to present basic and diluted EPS for a participating security, as well as common stock. 12. Proponents of View B believe that this is consistent with the historical application of the two-class method and point out that in the deliberations of FAS 128, the Board merely decided to EITF Issue No Issue Summary No. 2, p. 8

9 retain the two-class method originally described in APB 15 and did not re-deliberate the specifics of that method. Proponents of View B believe that the original guidance related to participating securities from APB 15 and its related interpretations, although technically superseded by FAS 128, are helpful for a proper understanding of this issue. Proponents of View B point to AIN 86, which provides additional guidance regarding the application of the two-class method for participating securities. AIN 86 states, in part: Two-Class Method for Nonconvertible Securities Q - How is the two-class method applied for nonconvertible securities? A - The two-class method for nonconvertible securities is an earnings allocation formula which determines earnings per share for each class of common stock and participating security according to dividends paid and participation rights in undistributed earnings. Under the two-class method, net income is first reduced by the amount of dividends actually paid for the period to each class of stock and by the contractual amount of any dividends (or interest on participating income bonds) which must be paid (for example, unpaid cumulative dividends or dividends declared during the period and paid during the following period). The remaining unencumbered undistributed earnings is secondly allocated to common stock and participating securities to the extent each security may share in earnings. The total earnings allocated to each security is determined by adding together the amount allocated for dividends and the amount allocated for a participation feature. This amount is 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. For this computation, outstanding common stock (the "ordinary" class of common stock) includes the usual common stock equivalent securities assumed to be converted or exercised for primary computations and includes these securities and all other potentially dilutive securities assumed to be converted or exercised for fully diluted computations. Although reporting earnings per share for each class of security may be desirable, earnings per share must be reported for the "ordinary" class of common stock. [Emphasis added.] 13. Proponents of View B believe that based on the above excerpt, it is quite clear that there has never been a requirement that EPS be presented for a participating security. However, proponents of View B note that the information required to compute basic and diluted EPS for a participating security should be contained elsewhere in the financial statements. EITF Issue No Issue Summary No. 2, p. 9

10 Issue 1(a): If the two-class method does not require the presentation of basic and diluted EPS for a participating security, when is it appropriate to present basic and diluted EPS for the participating security. FASB Staff View: The determination of whether basic and diluted EPS should be presented for a participating security is a matter of judgment that depends upon the relevant facts and circumstances. However, certain indicators may be useful in making that determination. 14. The FASB staff believes that the nature and types of participation rights of participating securities are too varied to construct a comprehensive approach for determining whether basic and diluted EPS should be presented for a participating security. Accordingly, the determination of whether to present basic and diluted EPS for a participating security is a matter of judgment that depends on the relevant facts and circumstances. However, certain indicators (none of which should be considered presumptive or determinative) may be useful in making that determination. Indicators that basic and diluted EPS should be presented for a participating security The participating security represents another class of common stock, and EPS calculations are easily performed. For example, a participating security that has no "shares," such as a convertible bond, does not lend itself to preparing an EPS calculation whereas a participating preferred stock that fully participates in all dividends declared (whether on a reduced ratio) would. The value of the participating security is derived in large part from the value of the issuing entity to which it is related, and changes in the value of the participating security tend to reflect changes in the value of the issuing entity and the common stock of the issuing entity. The participating security clearly derives a major portion of its value from its participation rights. EITF Issue No Issue Summary No. 2, p. 10

11 The buyer paid a premium for the feature of participation rights, that is, the price paid for the participating security was higher than the fair value of a similar security with similar characteristics, except for the participation rights. Marketplace participants have lowered their perceived value of the common stock of the issuing entity, as the participating security is viewed as being equivalent to the common stock of the issuing entity. The participating security is designed to provide the holder with both (a) a preferential distribution prior to the holders of the common stock of the issuing entity and (b) the right to share in the potential benefits of the undistributed earnings of the issuing entity through the participation rights. The participation rights of the participating security require that both earnings and losses be allocated to the participating security. Issue 2: How to define a participating security that requires application of paragraph 61 of FAS 128. View A: A security that provides the holder with participation rights that is, the contractual rights to receive dividends or returns from the security issuer's profits, cash flows, or returns on investments, where contractual rights encompass both those that are conditioned on the occurrence of a specified event and those that are not constitutes a participating security as that term is used in FAS Proponents of View A believe that the concepts discussed in both FAS 128 and FAS 129 should be used to define the term participating security for purposes of applying the guidance contained in paragraphs 60 and 61 of FAS 128. Both FAS 128 and FAS 129 were exposed for comment in the Capital Structure ED. Proponents of View A point out that the Board subsequently decided to issue separate statements primarily in order to avoid confusion as the EPS guidance was only applicable to public companies while the disclosures about capital structure were applicable to all entities. EITF Issue No Issue Summary No. 2, p. 11

12 16. Proponents of View A contend that, since the guidance contained in the Capital Structure ED related to participating securities and the two-class method as defined in earlier EPS guidance was retained by the Board during its re-deliberations of that exposure draft, the original guidance used in the exposure draft provides the best indication of how the Board intended to define the term participating security. Proponents of View A believe that there are three specific passages in the Capital Structure ED, as originally exposed, that are instrumental in composing a definition of a participating security for purposes of applying the guidance in paragraphs 60 and 61 of FAS 128. Those passages are: Paragraph 52(a) (which was subsequently carried forward to paragraph 60(a) of FAS 128) describes participating securities as "securities that may participate in dividends with common stocks" Paragraph 53 (which was subsequently carried forward to paragraph 61 of FAS 128) states, "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" The glossary definition of participation rights (which was later carried forward to paragraph 2 of FAS 129, with inconsequential modifications), which states, "participating rights are contractual rights of security holders to receive dividends or returns from the security issuer's profits, cash flows, or returns on investments, and so forth." 17. Based on the above references contained in the Capital Structure ED that were subsequently carried forward to FAS 128 and FAS 129, proponents of View A believe that it is clear that, for purposes of applying the guidance in paragraphs 60 and 61 of FAS 128, a participating security is a security that provides its holder with participation rights that is, contractual rights to receive dividends or returns from the security issuer's profits, cash flows, or returns on investments, regardless of whether those rights are conditioned upon the occurrence of a specific event or not. 18. Proponents of View A believe the notion that a participating security can participate in earnings through either dividends or other methods is consistent with the Board's view of a EITF Issue No Issue Summary No. 2, p. 12

13 convertible security and the use of the if-converted method. Proponents of View A point to paragraph 113 of FAS 128 which states: Other securities that could result in the issuance of common shares, in addition to options and warrants, are debt and preferred stock that are convertible into common stock. The impact of those potential common shares on diluted EPS is determined by use of the if-converted method. That method recognizes that the holders of convertible preferred stock cannot share in distributions of earnings available to common stockholders unless they relinquish their right to senior distributions. Conversion is assumed, and income available to common stockholders is determined before distributions are made to holders of those securities. Likewise, the if-converted method recognizes that convertible debt can participate in earnings through interest or dividends, either as a senior security or as common stock, but not both. [Emphasis added.] 19. Proponents of View A further believe that "contractual rights" as used in FAS 129 was intended to be consistent with its usage in other FASB statements. Those proponents of View A point to footnote 3 of FAS 107, which states that "contractual rights encompass both those that are conditioned on the occurrence of a specified event and those that are not." Accordingly, proponents of View A believe that same usage should be attributed to the use of contractual rights in FAS Proponents of View A note that their proposed definition of a participating security is consistent with the Board's recent deliberations. Those proponents point out that the Board recently considered the computation of EPS when undistributed earnings are somehow encumbered by the claim resulting from the "participation rights" of a participating security and concluded that those encumbered earnings must not be included in earnings available to common shareholders, as they would incorrectly inflate EPS. Those proponents of View A point to paragraph B69 of FAS 150, which states: The Board noted that some amounts attributable to shares that are to be redeemed or repurchased, for example, amounts associated with participation rights such as a preferred instrument that entitles the holder to participate in 50 percent of all future declared dividends on common shares, are not recognized as interest costs until the dividend is declared under this Statement or other existing standards. The Board concluded that earnings available to common shareholders (the numerator of the earnings per share calculation) should be reduced by EITF Issue No Issue Summary No. 2, p. 13

14 amounts attributable to participation rights as those rights are earned, consistently with the "two-class" method required by Statement 128. [Emphasis added.] View B: For purposes of applying paragraphs 60 and 61 of FAS 128, a participating security is a security that may participate in dividends with common stocks, whether that participation is conditioned upon the occurrence of a specified event or not. 21. Proponents of View B acknowledge that FAS 128 and FAS 129 were exposed together; however, View B proponents believe that only the concepts and language that was ultimately retained in FAS 128 should be used to define participating security for the purpose of applying paragraphs 60 and 61 of FAS 128. Proponents of View A believe that the example of a participating security used in paragraph 60(a) of FAS 128 clearly indicates which securities the Board considered to be participating securities. Those proponents believe that FAS 128 clearly states the Board's understanding that a participating security is a security that may participate in dividends with common stocks. Proponents of View B do agree however that "participation" would include dividend participation that is conditioned upon the occurrence of a specified event as paragraph 60(a) of FAS 128 clearly states that the participating security "may" participate in dividends. 22. Opponents of View B believe that employing such a rigid definition of a participating security (that is, that it participates through dividends) may result in entities structuring certain securities to participate in earnings through a mechanism that avoids the use of dividends so that they are not participating securities and therefore do not apply the two-class method to allocate earnings between the participating security and the common stock. Opponents of View B believe the economic substance of two securities which have the same rights to earnings, only one gets distributed through dividends and one does not, is the same. 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, convertible debt, and convertible preferred stock) may be participating securities. EITF Issue No Issue Summary No. 2, p. 14

15 View A: Yes. All potential common shares, that is, securities or other contracts that may entitle their holders to obtain common stock, regardless of their form, for example, options, warrants, forwards, convertible debt, and convertible preferred stock, may represent convertible participating securities. 23. Proponents of View A believe that all potential common shares, that is, securities or other contracts that may entitle their holders to obtain common stock, regardless of their form, such as options, warrants, convertible debt, and convertible preferred stock, may be participating securities. Proponents of View A believe that when the Board deliberated FAS 128, it did not intend that participating securities and potential common shares should be considered as two distinct items, otherwise FAS 128 would have noted the distinction in the definition of securities. Instead, the Board intended that all potential common shares could, potentially, be considered convertible participating securities if they have participating rights. 24. Proponents of View A believe that when the board considered the term "participating security" it considered the same definition of security contained in the glossary of FAS 128 that was used throughout the statement, namely, "the evidence of debt or ownership or a related right. For purposes of this Statement, it includes options and warrants as well as debt and stock." Further, proponents of View A point to the definition of "option" in the glossary of FAS 128, which specifically states that "options are considered 'securities' in this Statement." 25. Proponents of View A believe that if a participating security was not meant to apply the same broad definition of security used throughout FAS 128, the Board would have clarified that. View B: Only those potential common shares that are "convertible" into common stock may be participating securities. Agreements that may result in the issuance or acquisition of common stock such as options, warrants, forward sales or other contracts to issue or acquire common stock cannot be participating securities. The dilutive effect of those common stock arrangements should be included in the computation of EPS using the guidance contained in FAS 128 and other authoritative pronouncements. EITF Issue No Issue Summary No. 2, p. 15

16 26. Proponents of View B believe that only those potential common shares that are "convertible" into common stock may be participating securities. Agreements that may result in the issuance or acquisition of common stock such as options, warrants, forward sales, or other contracts to issue or acquire common stock, cannot be participating securities. The dilutive effect of those common stock arrangements should be included in the computation of EPS using the appropriate guidance contained in FAS 128 and other authoritative pronouncements. 27. Proponents of View B believe that only certain potential common shares can be participating securities. The distinction is that the potential common share must have substance apart from the common stock. Accordingly, contractual arrangements that may simply result in the issuance or acquisition of common stock, for example arrangements such as options, warrants, forward sales, or other contracts to issue or acquire common stock, are not participating securities. Proponents of View B believe that the holder has nothing more than the potential to become a common shareholder. There is no participating "security" outstanding, regardless of the participation rights associated with the arrangement. Proponents of View B support their view by pointing out the inconsistencies that result if a potential common share that had no substance apart from the common stock were considered a participating security. Those proponents point to employee stock option awards that receive dividend payments. Proponents of View B believe that FAS 128 contains specific guidance for the treatment of those arrangements that would preclude the use of the two-class method for including employee stock options in EPS. Proponents of View B specifically point to paragraph 32 of FAS 123, which requires "dividends or dividend equivalents paid to employees on the portion of an award of stock or other equity instruments that vests shall be charged to retained earnings," and paragraph 17 of FAS 128, which requires employee stock options to be included in the computation of diluted EPS using the treasury stock method. Proponents of View B further note that paragraph 17 of FAS 128 actually applies to options and warrants (and their equivalents). 28. Proponents of View B believe that similar items should be accounted for similarly and that employee stock option awards that provide dividend protection to an employee and an option to purchase shares that provides dividend protection, should both be included in the computation of diluted EPS in a similar manner. Proponents of View B point out that contracts to issue or EITF Issue No Issue Summary No. 2, p. 16

17 acquire common stock should be included in the computation of diluted EPS using either the treasury stock method or the reverse treasury stock method, or should be excluded from the computation of diluted EPS if their effect is anti-dilutive. Issue 2(b): Whether dividends or dividend equivalents paid to the holder of a convertible participating security that either reduce the conversion price or increase the conversion ratio of the security represent participation rights. NOTE: The FASB staff would like to discuss this Issue at the September 16, 2003 EITF Meeting. Issue 3: How undistributed earnings should be allocated to a participating security. 29. The following examples will be used to further explain the views contained in this Issue Summary. 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. 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 (for example, management discretion, market price of a security, achievement of certain earnings level, or liquidation). Example 5: A participating security that provides the holder with the ability to participate in dividends in excess of a specified threshold. Such a participation right would also include participation in extraordinary dividends and either: The classification of dividends as extraordinary is within the sole discretion of the Board of Directors, or The classification of the dividend is predetermined by a formula, for example, any dividend in excess of five percent of the current market price of the stock is defined as extraordinary. Example 6: 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 all "normal" or ordinary dividends and either: EITF Issue No Issue Summary No. 2, p. 17

18 The classification of the dividend as extraordinary is within the sole discretion of the Board of Directors, or The classification of the dividend is predetermined by a formula, for example, any dividend in excess of five percent of the current market price of the stock is defined as extraordinary. View A: In accordance with paragraph 61(b) of FAS 128, undistributed earnings should be allocated between common stock and a participating security "as if all of the earnings for the period had been distributed." 30. Proponents of View A believe that undistributed earnings should be allocated between common stock and a participating security using the premise contained in paragraph 61(b) of FAS 128, that is, that undistributed 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." Proponents of View A believe that an entity should consider how the undistributed earnings would be distributed in the event of a hypothetical distribution, and allocate the undistributed earnings in such a manner. 31. Proponents of View A acknowledge that in some instances, the manner in which undistributed earnings will be allocated may not be the manner in which those earnings will be eventually distributed, and, further, that in certain circumstances, the Board of Directors may be able to control how the dividends are actually paid so that the allocations may not reflect the ultimate distributions. Proponents of View A believe that this is consistent with the concept of the two-class method, as that method allocates earnings in order to compute EPS for the entity for the period. That measure of EPS is not meant to portray the ultimate distributions that will occur. 32. Proponents of View A point out this is not a liquidation presumption, as other senior securities may have preferences in liquidation, but, rather, it is an allocation of the undistributed earnings of the entity as if all earnings for the period were distributed. 33. Proponents of View A believe that undistributed earnings would be allocated to the participating securities as follows: EITF Issue No Issue Summary No. 2, p. 18

19 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: If all of the undistributed earnings had been distributed, they would 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 in dividends declared with the holders of common stock contingent upon the occurrence of a specified event (for example, management discretion, market price of a security, achievement of certain earnings level, liquidation). Evaluation: If all of the undistributed earnings had been distributed, they would not be allocated to the participating security unless the conditions in paragraph 30 of FAS 128 were met. Example 5: A participating security that provides the holder with the ability to participate in dividends in excess of a specified threshold. Such a participation right would also include participation in extraordinary dividends and either: The classification of dividends as extraordinary is within the sole discretion of the Board of Directors, or The classification of the dividend is predetermined by a formula, for example, any dividend in excess of five percent of the current market price of the stock is defined as extraordinary. Evaluation: If all of the undistributed earnings had been distributed, in either situation, the participating security would be allocated the portion of undistributed earnings that represents an extraordinary dividend. If extraordinary dividend were not defined, management would need to make assumptions regarding the definition of extraordinary in order to allocate undistributed earnings. Example 6: 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 all "normal" or ordinary dividends and either: The classification of the dividend as extraordinary is within the sole discretion of the Board of Directors, or The classification of the dividend is predetermined by a formula, for example, any dividend in excess of five percent of the current market price of the stock is defined as extraordinary. Evaluation: If all of the undistributed earnings had been distributed, in either situation, the participating security would be allocated the portion of undistributed earnings that represents an ordinary dividend. If extraordinary dividend were not defined, management EITF Issue No Issue Summary No. 2, p. 19

20 would need to make assumptions regarding the definition of extraordinary in order to allocate undistributed earnings. 34. Opponents of View A believe that the allocation of undistributed earnings to a participating security based upon arbitrary assumptions is not appropriate. Opponents of View A believe that an assumption that all of the earnings had been distributed is unrealistic, as an entity could certainly restrict its distributions over time to change the actual results from the reported EPS. Opponents of View A point to the example of a participating security that only participates in extraordinary dividends, where extraordinary dividends are defined as dividends in excess of 5 percent of the fair value of the participating security. If an entity assumes that all undistributed earnings were distributed at the end of the period, this would result in allocating the excess of 5 percent over the fair value to the participating security; however, in reality, the entity could only pay small dividends each year in order to avoid ever having to pay a dividend to the participating security. Opponents of View A question the relevance of presenting such a measure of EPS and believe that such an approach results in misleading if not manipulated EPS data for that period. View B: Undistributed earnings should be allocated to a participating security based upon the participation rights of the security to share in those earnings. If there are no stated participation rights, then undistributed earnings should not be allocated based upon arbitrary assumptions or premises. Participation rights that are contingent should be fully disclosed in accordance with paragraph 4 of FAS Proponents of View B believe that undistributed earnings should be allocated to a participating security based upon the participation rights of the security to share in those earnings. In circumstances where a participating security does not have stated participation rights for undistributed earnings, undistributed earnings should not be allocated based upon arbitrary assumptions or premises. However, participation rights that are contingent should be fully disclosed in accordance with paragraph 4 of FAS 129. Proponents of View B believe that consistent with the purpose of the two-class method, undistributed earnings should be allocated to the participating security based upon its participation rights in those undistributed current earnings and an entity should not arbitrarily assume how to allocate undistributed earnings or assume a hypothetical distribution of all earnings at the end of the period. EITF Issue No Issue Summary No. 2, p. 20

21 36. Proponents of View B believe that since the Board merely decided to the retain the requirement to use the two-class method originally prescribed in APB 15 and did not redeliberate the specifics of that method, the method remained the same. Further, those proponents feel that a review of evolution of the original guidance related to the application of the two-class method is required for a proper understanding of the allocation of undistributed earnings under the two-class method. Those proponents point to AIN 86, which stated the following, in part: Under the two-class method, net income is first reduced by the amount of dividends actually paid for the period to each class of stock and by the contractual amount of any dividends (or interest on participating income bonds) which must be paid (for example, unpaid cumulative dividends or dividends declared during the period and paid during the following period). The remaining unencumbered undistributed earnings is secondly allocated to common stock and participating securities to the extent each security may share in earnings. The total earnings allocated to each security is determined by adding together the amount allocated for dividends and the amount allocated for a participation feature. [Emphasis added.] 37. That guidance became the foundation for paragraph 61(c) of FAS 128. Proponents of View B acknowledge proponents of View A's contention that there is a change in the guidance that was carried forward to paragraph 61(c); however, those View B proponents point out that those changes were made in order to resolve ambiguities in the guidance, not to change the earnings allocation methodology or create a hypothetical allocation premise. Those proponents point out that paragraph 53(c) of the Capital Structure ED stated the following: The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings. 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. Paragraph 61(c) of FAS 128, however, was changed to the following: 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 EITF Issue No Issue Summary No. 2, p. 21

22 security shall be determined by adding together the amount allocated for dividends and the amount allocated for a participation feature. 38. Proponents of View B note that the staff made the change in order to avoid confusion in those situations in which a particular security's claim on earnings does not accumulate, not in order to create a new premise for the allocation of undistributed earnings. That is, the staff intended to clarify that consistent with the guidance contained in paragraph 9 of FAS 128, that only those dividends that accumulate are considered in the allocation of undistributed earnings. Proponents of View B further note that a corresponding change was made to footnote 25 of FAS 128 to clarify that dividends declared in a prior year but paid in the current year, are not included in dividends declared. 39. Accordingly, proponents of View B disagree with proponents of View A that there should be an assumption that undistributed earnings should be allocated between common stock and a participating security "as if all the earnings for the period were distributed." Instead, proponents of View B believe that undistributed earnings should be allocated to a participating security based on the participation rights of the security to share in those current earnings. Proponents of View B believe that their view is consistent with the conclusions reached by the Board in recent deliberations regarding FAS 150. Those proponents of View B point to paragraph B69 of FAS 150 which states: The Board noted that some amounts attributable to shares that are to be redeemed or repurchased, for example, amounts associated with participation rights such as a preferred instrument that entitles the holder to participate in 50 percent of all future declared dividends on common shares, are not recognized as interest costs until the dividend is declared under this Statement or other existing standards. The Board concluded that earnings available to common shareholders (the numerator of the earnings per share calculation) should be reduced by amounts attributable to participation rights as those rights are earned, consistently with the "two-class" method required by Statement 128. [Emphasis added.] 40. Proponents of View B believe that either a participating security has stated participation rights in undistributed earnings or it does not. Earnings available to common shareholders EITF Issue No Issue Summary No. 2, p. 22

23 should only be reduced when there is a stated participation right. Consider Example 6 from FAS 128 which provides the following example of a participation right in undistributed earnings: The preferred stock was entitled to a noncumulative annual dividend of $5 per share before any dividend is paid on common stock. After common stock has been paid a dividend of $2 per share, the preferred stock then participates in any additional dividends on a 40:60 per-share ratio with common stock. (That is, after preferred and common stock have been paid dividends of $5 and $2 per share, respectively, preferred stock participates in any additional dividends at a rate of two-thirds of the additional amount paid to common stock on a per-share basis.) 41. Proponents of View B believe that in the above example, the participating security has a participation right in all undistributed earnings. Proponents of View B are quick to point out, however, that having a participation right is not a guarantee that those earnings will be paid to the holders of the participating security. In the above example, the entity could pay a dividend in the following year that would distribute those remaining earnings from the prior year. Such a dividend would result in a higher amount paid to preferred shareholders than was allocated. However, the stated participation rights provide a framework from which to base an allocation and, therefore, gauge the performance of the entity consistent with the purpose of EPS. 42. Proponents of View B observe that there are only two types of participating securities: those that have stated participation rights and those whose participation is contingent and should be disclosed in accordance with FAS 129. Proponents of View B believe that participating securities that participate only in certain dividends, that is, dividends above or below a certain threshold (for example, a participating security that participates in either all ordinary or all extraordinary dividends), represents contingent participation that should be disclosed. 43. Proponents of View B believe that undistributed earnings would be allocated to the participating securities as follows: 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. EITF Issue No Issue Summary No. 2, p. 23