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. 1 * Date Prepared: May 8, 2003 FASB Staff: Degano (ext. 337) / Martin (ext. 342) Date Previously Discussed: None Previously Distributed EITF Materials: None 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) 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 Computation of Basic Earnings per Share" (Topic D-95) 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) * 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. 1, p. 1

2 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 retain the two-class method of computing EPS for enterprises with participating securities. 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 further states: 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. Questions have arisen as to what constitutes a participating security and when participating securities require the application of the two-class method. 3. This Issues considers how a "participating security" should be defined for purposes of applying paragraphs 60 and 61 of FAS 128, and whether paragraph 61 of FAS 128 requires an entity to use the two-class method in computing EPS based on the presence of a non-convertible 1 participating security, regardless of the characteristics of that participating security. Depending on the interpretation of the requirements of paragraph 61, this Issue also discusses how to determine whether a non-convertible participating security requires an entity to use the two-class method in computing EPS. 1 Paragraph 61 of FAS 128 and Topic D-95 require that a convertible participating security would be included in the EPS computation using the if-converted method unless the two-class method is more dilutive. EITF Issue No Issue Summary No. 1, p. 2

3 Accounting Issues and Alternatives Issue 1: How to define a participating security for purposes of applying paragraphs 60 and 61 of FAS 128. View A: For purposes of applying paragraphs 60 and 61 of FAS 128, a participating security is 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. 4. 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. 5. 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 what the Board intended the term participating security to mean. 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" EITF Issue No Issue Summary No. 1, p. 3

4 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." 6. 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. 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. 7. 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 what the Board considered a participating security to be. 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. EITF Issue No Issue Summary No. 1, p. 4

5 Issue 2(a): Whether paragraph 61 of FAS 128 requires an entity to use the two-class method in computing EPS based on the presence of a non-convertible participating security, regardless of the characteristics of that participating security. View A: Paragraph 61 of FAS 128 requires an entity to use the two-class method in computing EPS for capital structures including any type of non-convertible participating security, regardless of the characteristics of that participating security. 8. Proponents of View A believe that paragraph 61 of FAS 128 requires an entity to use the two-class method for calculating EPS when a non-convertible participating security is present regardless of the participation characteristics of that security. Proponents of View A believe that paragraph 61 of FAS 128 explicitly does not state that the two-class method is applicable only for certain participating securities, but states instead: 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. [Emphasis added.] 9. Proponents of View A believe that if the Board intended that only certain participating securities require the use of the two-class method, then the Board would have explicitly stated that the guidance contained in paragraphs 60 and 61 may be applicable in some but not all circumstances or simply that the presence of certain participating securities may require the use of the two-class method. Proponents of View A point out that such a distinction previously appeared in APB 15 and, since FAS 128 does not include similar language, the Board must not have intended for that distinction to be retained. 10. Proponents of View A believe that opponents of their view are concerned with how to allocate earnings to participating securities that do not guarantee participation, but merely enable EITF Issue No Issue Summary No. 1, p. 5

6 participation. Proponents of View A acknowledge such concerns; but point to Topic D-15 (which was rescinded by the SEC upon the issuance of FAS 128), which stated the following: First, securities that enable the holder to participate with common shareholders in dividends over a significant period of time should be reflected in earnings per share using the two-class method if more dilutive than other methods. Reflecting participating rights only when dividends are declared or paid is not an acceptable method for SEC filings (unless that produces a more dilutive earnings-per-share amount). [Emphasis added.] Proponents of View A believe that the concept that a security that provides an opportunity for the holder (rather than entitles the holder) to participate in dividends requires the application of the two-class method is consistent with the language contained in FAS 128 and FAS 129. Proponents of View A point to paragraph 60(a) of FAS 128, which states (in part) that a participating security "may participate in dividends with common stock according to a predetermined formula"(emphasis added), and paragraph 2 of FAS 129, which states (in part) that participation rights are "contractual rights of the security holders to receive dividends or returns." Proponents of View A believe that the meaning of contractual rights was intended to be similar to its meaning in other FASB literature, such as 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." Proponents of View A believe that both paragraphs imply that a participating security provides an opportunity for the holder to participate in dividends, but does not guarantee participation. Accordingly, proponents of View A believe that notwithstanding questions regarding how to allocate the undistributed earnings, the two-class method must be employed when a participating security is present. 11. Opponents of View A contend that the guidance contained in FAS 128 related to participating securities and the two-class method was carried forward without reconsideration by the Board, and that in order to understand its application one must consider other guidance contained in APB 15 and its related interpretations. Opponents of View A specifically observe that paragraph 60 of APB 15, which stated that "dividend participation does not per se make a security a common stock equivalent," fully refutes the assertion of View A proponents that all participating securities require an entity to use the two-class method. Further, opponents of EITF Issue No Issue Summary No. 1, p. 6

7 View A believe that certain interpretive guidance related to APB 15, specifically AIN85, clearly stated that certain participating securities would not necessitate the use of the two-class method. Opponents of View A are also quick to point out that the title of Topic D-15 refers to securities not specifically covered by APB 15, and that it has been acknowledged that participating securities were specifically addressed by APB 15. Opponents of View A believe that the original purpose of Topic D-15 was not to provide guidance on the accounting for participating securities, but, rather, to discuss paragraph 43 of APB 15, which required that situations not explicitly described in APB 15 were to be dealt with in accordance with the principles of that Opinion. View B: Paragraph 61 of FAS 128 does not require an entity to use the two-class method in computing EPS for capital structures including any type of non-convertible participating security. 12. Proponents of View B believe that the mere presence of a participating security does not require an entity to use the two-class method in computing EPS. Proponents of View B believe that the Board decided to retain the two-class method originally described in APB 15, and therefore, since it did not re-deliberate the specifics of that method, implicitly retained that method and any related guidance. Proponents of View B believe that a review of the original guidance related to participating securities from APB 15 and its related interpretations, although technically superseded by FAS 128, is required for a proper understanding of this issue. 13. The following discussion is an overview of the application of the two-class method for participating securities under APB 15 and its related interpretations as understood by the proponents of View B. APB 15 required the presentation of primary and fully diluted EPS. Primary EPS was "based on the outstanding common shares and shares that are in substance equivalent to common shares" (paragraph 15). Paragraph 25 of APB 15 elaborated more on that concept and stated: EITF Issue No Issue Summary No. 1, p. 7

8 A common stock equivalent is a security which is not, in form, a common stock but which usually contains provisions to enable its holder to become a common stockholder and which, because of its terms and the circumstances under which it was issued, is in substance equivalent to a common stock. The holders of these securities can expect to participate in the appreciation of the value of the common stock resulting principally from the earnings and earnings potential of the issuing corporation. This participation is essentially the same as that of a common stockholder except that the security may carry a specified dividend or interest rate yielding a return different from that received by a common stockholder. The attractiveness of this type of security to investors is often based principally on this potential right to share in increases in the earnings potential of the issuing corporation rather than on its fixed return or other senior security characteristics. With respect to a convertible security, any difference in yield between it and the underlying common stock as well as any other senior characteristics of the convertible security become secondary. The value of a common stock equivalent is derived in large part from the value of the common stock to which it is related, and changes in its value tend to reflect changes in the value of the common stock. Neither conversion nor the imminence of conversion is necessary to cause a security to be a common stock equivalent. [Emphasis added.] Paragraph 27 of APB 15 indicated that certain participating securities are or may be considered a common stock equivalent. That paragraph stated (in part): Participating securities and two-class common stocks if their participation features enable their holders to share in the earnings potential of the issuing corporation on substantially the same basis as common stock even though the securities may not give the holder the right to exchange his shares for common stock (see paragraphs 59 and 60). Paragraph 59(a) of APB 15 provided further insight into the definition of a participating security. That paragraph stated: Securities which 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). The language used to describe participating securities in the paragraph above, describes the participation features historically linked to participating preferred stock. Certain accounting references contain detailed descriptions of such participation features. Kieso & Weygandt's EITF Issue No Issue Summary No. 1, p. 8

9 Intermediate Accounting (sixth edition page 699) states the following regarding participating preferred stocks: Participating. Holders of participating preferred stock share ratably with the common stockholders in any profit distributions beyond the prescribed rate. That is, 5% preferred stock, if fully participating, will receive not only its 5% return, but also dividends at the same rates as those paid to common stockholders if amounts in excess of 5% of par or stated value are paid to common stockholders. Also, participating preferred stock many not always be fully participating as described, but partially participating. For example, provision may be made that 5% preferred stock will be participating up to a maximum total rate of 10%, after which it ceases to participate in additional profit distributions; or 5% preferred stock may participate only in the additional profit distributions that are in excess of a 9% dividend rate on the common stock. [Emphasis added.] In paragraph 15, APB 15 was careful to state that "earnings per share computations relating to certain types of participating securities may require the use of the two-class method" (emphasis added). However, APB 15 specifically stated that simple dividend participation does not make a participating security a common stock equivalent; instead, an analysis of all factors was required to make such a determination. Paragraph 60 of APB 15 stated: Because of the variety of features which these securities possess, frequently representing combinations of the features referred to above, it is not practicable to set out specific guidelines as to when they should be considered common stock equivalents. Dividend participation does not per se make a security a common stock equivalent. A determination of the status of one of these securities should be based on an analysis of all the characteristics of the security, including the ability to share in the earnings potential of the issuing corporation on substantially the same basis as the common stock. [Emphasis added.] Subsequent to the issuance of APB 15, questions continued to arise regarding which participating securities required the application of the two-class method. As a result, the AICPA issued AIN 85, AIN 86, and AIN 87, which provided additional guidance regarding the determination of which participating securities required the application of the two class method and provided examples of the computation of the two class method for both convertible and non-convertible participating securities. AIN 85 stated (in part): EITF Issue No Issue Summary No. 1, p. 9

10 EPS Treatment of Two-Class and Participating Securities Two-class common is a term applied when a corporation has issued more than one class of common stock (for example, Class A and Class B). A participating security is a security eligible to participate in dividends with common stock; often a fixed amount is guaranteed to the participating security, then common is paid a dividend at the same rate, and the security participates with common on a reduced ratio thereafter. Classes of common stock other than "ordinary" common stock and the participating securities may be convertible into "ordinary" common stock or may be nonconvertible and may or may not be senior to common stock. For example, some stocks may be designated as common stock (e.g., Class B Common), but their terms and conditions are equivalent to preferred stock (by limiting their voting rights or the amount of dividends they may receive and by giving them preferences in liquidation). If dividends are guaranteed in some way but limited in participation to a maximum amount for a particular class of common stock, that common stock is considered the equivalent of a senior security to the extent it is to share in earnings. If dividend participation for a particular class of common stock is not limited but the participation is at a rate different from the "ordinary" common stock (for example, participating equally to some amount per share and partially participating thereafter), the two-class method is used. The two-class method is also used for participating preferred stock which is not limited as to participation in dividends with common stock. The two-class method is modified, however, when it is applied for a convertible security. (See Interpretation 87.) To be applied for a convertible security, the two-class method must result in greater dilution than would result from application of the if converted method. A determination of the status of a two-class common stock or other participating security as a common stock equivalent or as an other potentially dilutive security is based on an analysis of all the characteristics of the security, including the ability to share in the earnings potential of the issuing corporation on substantially the same basis as the common stock. Dividend participation per se does not make such a security a common stock equivalent. [Emphasis added.] 14. Based on the above discussion of participating securities contained in APB 15 and its related interpretations, proponents of View B believe that it is clear that while the following securities are all participating securities, only the first two participating securities were considered common stock equivalents that would have required the use of the two-class method under APB 15: EITF Issue No Issue Summary No. 1, p. 10

11 Common stock that is not limited in its participation rights in dividends (even if on a different rate than other classes of common stock) Preferred stock that participates in dividends (even if on a reduced ratio from other classes of common stock) and that participation is not limited, Common stock that participates in dividends up to a maximum amount, and Preferred stocks that participate in dividends up to a maximum amount. 15. Proponents of View B believe that based upon the guidance contained in APB 15 and its related interpretations, it is clear that the two-class method was never intended to be applied to all participating securities. Since, in its deliberations regarding FAS 128 and FAS 129, the Board decided to retain the two-class method for use by those enterprises with multiple classes of common stock and participating securities without discussing the topic any further, proponents of View B believe that it is clear that the Board did not intend to change the approach prescribed by APB 15 and its interpretations. Accordingly, proponents of View B do not believe that the presence of any non-convertible participating security would require the use of the twoclass method in computing EPS. Issue 2(b): If paragraph 61 of FAS 128 does not require an entity with a non-convertible participating security to use the two-class method in computing EPS, how an entity should determine whether the use of the two-class method is appropriate. View A: Only those non-convertible participating securities that (a) have participation rights that are not limited (regardless of whether such participation rights are different from that of the common stock) and (b) participate according to a pre-determined formula should apply the twoclass method in computing EPS. The terms of all other participating securities should be disclosed in accordance with paragraph 4 of FAS Proponents of View A believe that the previous guidance contained in APB 15 and its interpretations should be used to determine whether a participating security requires the use of the two-class method. Proponents of View A believe that based on APB 15 and its interpretations, the two-class method was only applied in situations in which the participating securities (a) had no limits placed on their participation rights that is, the holder of the security participated fully in dividends with the holders of common stocks (regardless of whether such EITF Issue No Issue Summary No. 1, p. 11

12 participation is at a different ratio than the common stock) and (b) participated according to a pre-determined formula. 17. Proponents of View A believe that for the two-class method to be appropriately applied there must be no question as to how to allocate earnings between the participating security and the common stock. Proponents of View A believe that if an entity applying the two-class method is unable to determine how to allocate earnings due to the lack of a pre-determined formula, then the two-class method should not be applied. Proponents of View A believe that if an entity were required to apply the two-class method in situations in which there is no predetermined formula to allocate undistributed earnings between the common stock and the participating security, the application of the two-class method may result in misleading information for investors, as the entity may attribute earnings to participating securities that do not currently, and may never, share in those earnings especially when those earnings may be distributed to other securities. 18. Proponents of View A further believe that if application of the two-class method were required in situations in which the participating security did not participate according to a predetermined formula for the allocation of earnings, then such a requirement would result in arbitrary allocations that could be manipulated to make certain securities look better to the detriment of other securities. 19. Proponents of View A note that the terms of participating securities that, individually, do not necessitate the use of the two-class method in computing EPS should be disclosed in accordance with paragraph 4 of FAS 129. Proponents of View A further observe that an entity that issued a participating security that does not require the use of the two-class method, would need to adjust earnings available to the common shareholders by any distributions that would be made to holders of participating securities in the event that all of the undistributed earnings were distributed. View B: A non-convertible participating security that represents a second class of common stock (which may participate at a different rate than the common stock of an entity) requires the EITF Issue No Issue Summary No. 1, p. 12

13 use of the two-class method in computing EPS. A participating security that (a) has participation rights that are not limited and (b) participates according to a pre-determined formula (that is, a View A security) represents in substance another class of common stock that requires an entity to use the two-class method in computing EPS. However, other participating securities may also represent another class of common stock and, therefore, require the use of the two-class method. Participating securities that do not represent a second class of common stock should be disclosed in accordance with paragraph 4 of FAS Proponents of View B agree with proponents of View A that the guidance in APB 15 and its interpretations should be used to determine whether a participating security requires the use of the two-class method. Proponents of View B believe that since the two-class method is intended to treat participating securities as though they were effectively another class of common stock (even though they may participate at a different rate than the common stock of an entity), that principle is the one that should be evaluated when the two-class method is applied. Proponents of View B agree with proponents of View A that, in situations in which the participating security (a) has no limits placed on its participation rights, that is, the holder of the security participates fully in dividends with the holders of common stocks (regardless of whether such participation is at a different ratio than the common stock), and (b) participates according to a pre-determined formula, that participating security represents another class of common stock that requires the use of the two-class method. Proponents of View B, however, believe that other participating securities may also represent another class of common stock and, therefore, require the use of the two-class method. Those proponents point out that paragraph 60 of APB 15 emphasized that judgement was required in determining whether an entity with a participating security should use the two-class method. Proponents of View B acknowledge that there may be security structures with similarities to "View A securities" but that have subtle, nonsubstantive differences from the basic characteristics of a "View A security" that should require an entity to use the two-class method. 21. For this reason, proponents of View B offer the following observations that may indicate that a participating security represents a second class of common stock that requires the use of the two-class method: EITF Issue No Issue Summary No. 1, p. 13

14 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. 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. Not considering the participating security to require the use of the two-class method would be misleading, as 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. 22. Proponents of View B believe that a participating security that does not represent another class of common stock and, therefore, does not require an entity to use the two-class method in computing EPS should be disclosed in accordance with paragraph 4 of FAS Proponents of View B further observe that if an entity attempting to apply the two-class method is unable to determine how to allocate earnings due to the lack of a pre-determined formula, then that would be a strong indication that use of the two-class method would be inappropriate. 24. Proponents of View B further observe that an entity that issued a participating security that does not require the use of the two-class method, would need to adjust earnings available to the EITF Issue No Issue Summary No. 1, p. 14

15 common shareholders by those distributions that would be given to those holders of those participating securities were all of the earnings for the period to be distributed. Other Considerations 25. In the interest of achieving the Board's objective of simplification and codification, the FASB staff believes that the guidance contained in Topic D-95 and the consensuses reached in this Issue should be codified into one Issue. EITF Issue No Issue Summary No. 1, p. 15