February, 2 2012
The Impact of Convertibles and Detachables on Earnings Per Share
Issuing equity-linked financial instruments, such as convertible debt or warrants, can have an unexpected impact on earnings per share (EPS). The objective of this alert is to review the potential impact on routine equity-linked financing transactions.
The way EPS calculations are performed varies depending on the following:
- The type of financial instrument
- Individual facts and circumstances
- Management intent and ability (i.e., to settle in cash or shares)
- Contractual terms
The dilutive effect of convertible debt and convertible preferred stock is usually determined using the if-converted method
1, and the dilutive effect of options and warrants is usually determined using the treasury stock method
2.
Primer
EPS refers to a company’s earnings divided by the number of shares outstanding. For accounting purposes, both “basic EPS” and “fully diluted EPS” are calculated. Basic EPS is income available to common shareholders, divided by the weighted average number of common shares outstanding. Fully diluted EPS takes into account the dilutive effect of convertible securities and treasury stock, using the if-converted and treasury stock methods respectively.
Contingently convertible debt
Some debt converts into common shares when the underlying stock reaches a certain price. Such debt is included in diluted EPS if the effect is dilutive, whether or not the contingency is resolved. If conversion occurs and the company settles by delivering shares, the if-converted method is applied. If the company delivers cash up to the par value and shares for the conversion spread, the treasury stock method is used. If the contingency is not market related, it needs to be resolved before the debt can be included in diluted EPS. The most common contingencies pertain to share price reaching a certain level; for example, 110% of conversion price on or before maturity of the debt.
Company controls settlement
When the company gets to choose the settlement method, there is a presumption that share settlement should be used for EPS calculations. This presumption may only be overcome if the company can demonstrate that it has the intent and ability to settle some or all shares in cash upon conversion of the debt. This needs to be supported by past practice, written policy or both. Written policies must be deemed substantive, meaning there should be an evaluation of settlement alternatives and past disclosures to ensure consistency. A careful evaluation of liquidity and credit may also be required to demonstrate intent and the ability to settle using cash.
The SEC staff requires that the following factors be used to determine whether a company’s written policy has substance:
- Intent and ability to cash settle the entire instrument (principal and interest)
- Current and projected liquidity
- Management representation
- Settlement alternatives as a selling point
- Management can structure an instrument with any settlement terms it wants. Consider how important of a factor it is when a Company allows settlement choices versus when it issues an instrument that only allows a cash settlement
- Disclosure commensurate with intent
- Disclosures in financial statements and offering documents should support the company's intent and ability
- Past practice
Mandatorily redeemable preferred stock (MRPS)
The main difference between an MRPS and a regular perpetual preferred stock is that in MRPS, the issuer is committed to redeem the issue over a fixed period, usually at a premium in the early years, then declining to par in the terminal year.
When determining the income available to common shareholders from MRPS, accretions (or decrements) and dividends (including those "deemed”
3) represent adjustments to income from continuing operations. This applies to both basis and diluted EPS.
Mezzanine equity
Common stock classified as mezzanine equity should be viewed as possessing a preferential return if it is redeemable for an amount other than fair value. In such cases, an allocation of earnings from common shareholders is required
4. This applies not only to basic and diluted EPS, but to redeemable, non-controlling interests. Changes in the mezzanine carrying amount of redeemable common stock are accounted for as an allocation of income to holders.
Participating securities
Income related to participating securities should generally be calculated as a reduction of the numerator in basic EPS using the two-class method. The two-class method requires that basic EPS and fully diluted EPS be presented separately for participating securities and each class of common stock. This should be accomplished by allocating earnings, adjusted for any preferred-stock dividends, between common shareholders and participating security holders, based on their right to receive dividends as if all undistributed book earnings for the period were distributed. This holds true whether the securities are convertible, non-convertible or potential common stock securities. An assessment of whether the instrument holder is entitled to receive dividends must be made before any exercise, settlement, conversion or vesting.
Cash or share settlement
In certain situations, issuers are required to account for liability and equity components separately by allocating the proceeds between a liability component (debt) and an embedded conversion option (equity). The allocation is based on the interest rate of similar debt that is not convertible and usually results in a discount on the debt. Such a discount must be accreted as an interest expense over the instrument’s expected life, using the interest method. Any reduction in net income due to accretion of any debt discount, or gain or loss upon conversion has an impact on EPS.
Cash-settled instruments
For cash-settled instruments, an adjustment should be made to income available to common shareholders. This adjustment represents the income or loss that would result if the instrument had been accounted for as an asset or liability.
In the same manner, when the holder gets to choose the settlement method, the calculation (of assumed share settlement) should include an adjustment to the diluted EPS in the numerator to eliminate the effects of the instrument buried in net income and to include the impact of the share-settled contract in the denominator. Such instruments are generally accounted for as liabilities, with changes in fair value recognized in earnings.
Conclusion
If your company is thinking about issuing equity-linked securities, contact Pluris to discuss accounting and valuation alternatives. Pluris has extensive experience calculating convertible bifurcations, identifying embedded features and options, and valuing debt and equity instruments included when issuing equity-linked securities.
1 ASC 260-10-45-40 to ASC 260-10-45-42
2 ASC 260-10-45-22 to ASC 260-10-45-27
3 ASC 260-10-S99-2 and ASC 470-20-30
4 ASC 480-10-S99-3A
