AUGUST 2012 / THE CPA JOURNAL26

By Josef Rashty

Earnings per share (EPS) is one ofthe most common and complex per-formance measurements that a pub-

licly held company presents in its quarterlyand annual reports. (See Josef Rashty andJohn O’Shaughnessy, “Restricted StockUnites and the Calculation of Basic andDiluted Earnings per Share,” The CPAJournal, June 2011, pp. 40–45.) AccountingStandards Codification (ASC) Topic 260,“Earnings per Share,” covers guidance forthe calculation and presentation of basic anddiluted EPS, and ASC Topic 718,“Compensation—Stock Compensation,” pro-vides guidance for certain unique character-istics of stock compensation awards thatimpact the EPS calculation.

In their July 2005 CPA Journal article,“The Two-Class Method for EPS: Theory,Rule, and Implementation,” Nathan Slavinand Steven Petra discussed the calculationof basic EPS under the two-class stockmethod for certain participating securities,based on Emerging Issues Task Force(EITF) Issue 03-6, Participating Securitiesand the Two-Class Method Under FASBStatement No. 128.

The discussion below is based on FASBStaff Position (FSP) EITF 03-6-1,Determining Whether Instruments Grantedin Share-based Payment TransactionsAre Participating Securities, subsequentguidance effective for fiscal years begin-ning after December 15, 2008. This FSPwas subsequently codified under ASC 260-10-45-61-A and 68-B, and ASC 260-10-55-76-A through D. The discussionbelow explains and illustrates the applica-tion of the two-class method in the calcu-lation of basic and diluted EPS for stockcompensation awards that are consideredparticipating securities under ASC 260, andit highlights the complexities surroundingsuch calculations and related disclosures.

The Two-Class MethodThe two-class method is an earnings

allocation formula that treats participatingsecurities as having rights to earnings thatotherwise would have been available onlyto common shareholders. Complicationsarise during the application of the two-classmethod in the calculation of basic anddiluted EPS, primarily because of the com-

plexity of the calculation and the limitedapplication guidance under ASC 260 andin related accounting literature.

Certain companies issue stock compen-sation awards that contain rights to receivenonforfeitable dividends prior to the awardsbeing vested. Under ASC 260, such unvest-ed stock compensation awards are consid-ered participating securities and, as such,

A C C O U N T I N G & A U D I T I N G

a c c o u n t i n g

Stock Compensation Awards as Participating Securities

The Two-Class Stock Method for CalculatingEarnings per Share

must be included in the two-class methodcalculation of basic and diluted EPS,regardless of a company’s intention todeclare or commit to pay any dividends.These awards are considered participatingsecurities because the holders of the awardsparticipate in the distributions of earningswith common shareholders from the datethat the awards are granted.

By contrast, unvested stock compensa-tion awards that contain rights to receivedividends only if the awards are fully vest-ed do not represent a participation right.These awards are not considered partici-pating securities because the holders of theawards do not have the right to retain div-idends unless the employees have renderedthe requisite service and the awards arefully vested.

In practice, however, most companiesdesign their employee compensationplans in such a way that stock compensa-tion awards will not be considered partic-ipating securities. In other cases, the impact

of stock compensation awards as partici-pating securities have not been material(e.g., Hewlett-Packard Company, Form 10-Q for the period ended January 31, 2012,http://www.sec.gov/Archives/edgar/data/47217/000104746912002476/a2207600z10-q.htm). Nevertheless, there are manyother publicly held companies that haveclassified their stock compensation awardsas participating securities and have report-ed their EPS under the two-class method(e.g., Helmerich & Payne Inc., Form 10-Q for the period ended March 31, 2012,http://www.sec.gov/Archives/edgar/data/46765/000110465912032962/a12-5931_110q.htm).

Participating SecuritiesA company should determine if it has

any participating securities and whether itshould allocate earnings to those securities.A participating security is a security otherthan common stock that may participate inthe distribution of earnings, together with

common stock, in its current form. Thisparticipation may even be conditioned uponthe occurrence of a specified event. Oneexample of a participating security is acompany’s preferred stock with dividendparticipation rights, whereby the holderwould receive a cash dividend when div-idends are declared on common stock.

Participation does not have to be in theform of dividends, however; any form ofparticipation in undistributed earnings con-stitutes participation. For example, partic-ipating securities may participate in theundistributed earnings of a companythrough a formula tied to the dividends paidon common stock, such as a warrant enti-tling the holder to a “yield right” equal toa certain percentage of the dividends paidon common stock, even though this yieldright is not labeled as a dividend.

Applicability of losses. Generally, loss-es are not applicable to participating secu-rities. A publicly held company allocateslosses to a participating security in the peri-

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The following example reflects the computation of basic and diluted EPS when an entity has issued nonqualified stock options (NQSO). It reflects the calculation of basic anddiluted EPS both for NQSOs as nonparticipating securities and NQSOs as participating securities.

AssumptionsNet income (NI) $500,000Weighted average of common shares outstanding (WAS) 1,000,000Number of common shares outstanding at the end of the period (CSO) 1,000,000NQSOs granted at the beginning of the period1 100,000Grant price (exercise price) at the beginning of the period (EXP) $ 10Average stock price during the period (AVG) $ 15Black-Scholes-Merton valuation of NQSOs (FMV) $ 4Unrecognized stock compensation at the beginning of the period2 $400,000Stock compensation for the period $ 80,000Unrecognized stock compensation at the end of the period $320,000Average unrecognized stock compensation 3 $360,000Dividend declared and payable per common share $ 0.10Estimated forfeiture rate 20%Effective tax rate (ETR) 40%

1 NQSOs will be fully vested at the completion of four years; therefore, no options have been vested or exercised during the first year that EPS is calculated.2 Number of NQSOs grants (100,000) multiplied by the Black-Scholes-Merton valuation of $43 The simple average of unrecognized stock compensation at the beginning of the period for $400,000 and at the end of the period for $320,000

Calculation of basic and diluted EPS if NQSOs were not participating securities. In this scenario, the option holders do not have rights to participate in dividends with thecommon shareholders.

Basic EPS1 $0.5000Diluted EPS:

Assumed proceeds from the exercise of options 2 $1,000,000Average unrecognized compensation 360,000Excess tax benefits 3 40,000

Total assumed benefits $1,400,000Incremental diluting shares (IDS) 4 6,667Diluted shares outstanding (DSO) 5 1,006,667Diluted EPS 6 $0.4967

1 $500,000 (NI) ÷ 1,000,000 (WAS) = $0.50002 100,000 (NQSOs) × $10 (EXP) = $1,000,0003 ($15 [AVG] − $10 [EXP] − $4 [FMV] = $1 × 40% [ETR]) × 100,000 (NQSOs) = $40,0004 100,000 (NQSOs) − ($1,400,000 ÷ $15 [AVG]) = 6,6675 1,000,000 (WAS) + 6,667 (IDS) = 1,006,667 (DSO)6 $500,000 (NI) ÷ 1,006,667 (DSO) = $0.4967

Calculation of basic and diluted EPS if NQSOs were participating securities. In this scenario, the option holders have a nonforfeitable right to participate in dividends withthe common shareholders on a dollar-for-dollar basis.

Net income (NI) $500,000Less distributed income (DI)1 (108,000)Undistributed income (UI) $392,000

Average diluted shares outstanding (ADS) 1,100,000Average diluted expected-to-vest shares outstanding (AES) 1,080,000

1 1,000,000 (CSO) + (100,000 [NQSOs] × [80% or excluding the estimated forfeited awards]) = 1,080,000 × $0.10 (dividend) = $108,000

Common shares Basic EPS Diluted EPSDistributed earnings $0.10001 $0.09934

Undistributed earnings 0.35642 0.35425

Common shares EPS $0.4564 $0.4535

Unvested shares Basic EPS Diluted EPSDistributed earnings $0.08003 $0.08006

Undistributed earnings 0.35642 0.35425

Unvested shares EPS $0.4364 $0.4342

1 $0.10 dividend declared and paid to each common shareholder2 $392,000 (UI) ÷ 1,100,000 (ADS) = $0.35643 $80,000 of earnings distributed to 100,000 unvested NQSOs4 (1,000,000 CSO × $0.10 dividend declared) ÷ 1,006,667 (DSO) = $0.09935 $392,000 (UI) ÷ 1,106,667 (ADS plus IDS) = $0.35426 $80,000 dividend applicable to 80,000 NQSOs expected to vest ÷ 100,000 average unvested options outstanding

EXHIBIT 1An Illustration of the Two-Class Method

ods of net loss if, based upon the contrac-tual terms of the participating security,the security had not only the right to par-ticipate in the earnings of the issuer, butalso a contractual obligation to share in thelosses of the issuing entity on a basis thatwas objectively determinable. The compa-ny should determine whether the holder ofa participating security has an obligationto share in the losses of the issuing entityfor the calculation of EPS in a given peri-od, on a period-by-period basis.

Computing EPS Using the Two-ClassMethod

All securities, including stock compensa-tion awards, that meet the definition of a par-ticipating security—irrespective of whetherthe securities are convertible, nonconvertible,or potential common stock securities—should be included in the computation ofbasic and diluted EPS, using the two-classmethod. Under this method, a companyassumes that it distributes all of its earnings

to the holders of all outstanding participat-ing awards (not just those awards that areexpected to vest), which would ultimatelyreduce the earnings available for distributionto common shareholders. In other words, thetwo-class method is an earnings allocationformula that treats all participating securitiesas having rights to earnings that otherwisewould have been available only to com-mon shareholders.

The two-class method calculation, com-prising the sum total of EPS applicable todistributed and undistributed earnings, iscalculated as follows:■ Distributed earnings—First, the com-pany determines the amount of the divi-dends that it has declared in the currentperiod (dividends declared in the currentperiod should not include dividendsdeclared with respect to prior-year unpaidcumulative dividends) and is applicable toits common stockholders and its partici-pating securities. Second, the companyallocates the distributed earnings to an aver-

age number of common stock and an aver-age number of participating securities thatare expected to vest.■ Undistributed earnings—Third, thecompany reduces its income from contin-uing operations (or net income) by theamount of distributed earnings (calculatedabove). Fourth, the company allocates theundistributed earnings to an average num-ber of common stock and an average num-ber of participating securities.

It should be noted, however, that theamount of distributed earnings allocated tothe unvested stock compensation awardsequals the total dividends distributed toall stock compensation awards, minus thedividends applicable to awards that areexpected to be forfeited.

By contrast, the amount of undistributedearnings must be allocated to all outstand-ing awards, including awards that are expect-ed to be forfeited. This approach is basedon the assumption that, under the two-classmethod, an entity distributes its earnings to

29AUGUST 2012 / THE CPA JOURNAL

all outstanding awards (not just the awardsexpected to vest). Generally, the applicationof the two-class method reduces the earningsavailable to distribute to common share-holders. Exhibit 1 illustrates this concept.

Stock Compensation AwardsASC 260 requires that all awards be

included in the computation of diluted EPSas long as the effect is dilutive. Dilutivestock compensation awards (e.g., stock

options and restricted stock units) will beincluded in the diluted EPS computationeven if employees are not able to exercisethe awards until some future date.Companies determine the dilutive effect of

AUGUST 2012 / THE CPA JOURNAL30

EXHIBIT 2Computation of Basic and Diluted EPS by Helmerich & Payne Inc.

Three Months Ended Six Months EndedMarch 31, March 31,

2012 2011 2012 2011Numerator: Income from continuing operations $129,763 $98,961 $274,060 $203,326Loss from discontinued operations (44) (171) (55) (386)Net income 129,719 98,790 274,005 202,940Adjustment for basic EPS:Earnings allocated to unvested shareholders (530) (300) (1,009) (599)Numerator for basic earnings per share:From continuing operations 129,233 98,661 273,051 202,727From discontinued operations (44) (171) (55) (386)

129,189 98,490 272,996 202,341Adjustment for diluted EPS:Effect of reallocating undistributed earnings of

unvested shareholders 7 6 14 11Numerator for diluted EPS:From continuing operations 129,240 98,667 273,065 202,738From discontinued operations (44) (171) (55) (386)

$129,196 $98,496 $273,010 $202,352Denominator:Denominator for basic EPS—weighted-average shares 107,385 106,515 107,285 106,270Effect of dilutive shares from stock options and

restricted stock 1,657 2,080 1,640 2,105Denominator for diluted EPS—adjusted weighted-

average shares 109,042 108,595 108,925 108,375Basic earnings per common share:Income from continuing operations $1.20 $0.92 $2.54 $1.90Loss from discontinued operations — — — —Net income $1.20 $0.92 $2.54 $1.90Diluted earnings per common share:Income from continuing operations $1.18 $0.91 $2.51 $1.87Loss from discontinued operations — — — —Net income $1.18 $0.91 $2.51 $1.87

Figures in thousands, except per-share amounts Source: Helmerich & Payne Inc. Form 10-Q filed for the period ended March 31, 2012,http://www.sec.gov/Archives/edgar/data/46765/000110465912032962/a12-5931_110q.htm

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the stock compensation arrangements usingthe treasury stock method (TSM).

The use of forfeiture rates in the calcu-lation of basic and diluted EPS is consis-tent with the provisions of ASC Topic 780,“Stock Compensation.” Therefore, anychanges in the estimated number of for-feited share awards must be reflected in theEPS calculation in the period that a changein estimate occurs.

Treasury Stock MethodThe TSM assumes that a company

uses the proceeds from the hypotheticalexercise of the stock compensation awardsto repurchase common stock at the aver-age market price during the period (Rashtyand O’Shaughnessy 2011). Therefore,higher assumed proceeds (the numerator)and a lower average market price duringthe reporting period (the denominator)increases the number of shares that a com-pany can hypothetically repurchase. Anincrease in the number of shares that acompany can hypothetically repurchaselowers the denominator and raises theamount of diluted EPS.

The assumed proceeds under the TSMinclude the following:■ The purchase price of the award thatthe grantee pays in the future (usually theexercise price of the stock compensationawards)■ The average compensation costs forfuture services that have not been recognized■ Any windfall tax profits (or shortfalls)due to the exercise of awards.

Unvested stock compensation awardsthat contain nonforfeitable rights to divi-dends (or dividend equivalents) are par-ticipating securities, and should be includ-ed in the calculation of basic and dilutedEPS under the two-class method.

Participating and NonparticipatingSecurities

ASC 260 considers unvested stock com-pensation awards as participating securi-ties, as long as they participate in distri-butions of earnings with common share-holders from the grant date, and the granteeis not required to render any service to earnsuch dividends. The unvested stock com-pensation awards that contain rights toreceive dividends only upon full vestingare not participating securities, because theholders of the awards do not have the rightto retain the dividend unless they completethe requisite service period.

Dividends or dividend equivalents mayalso be transferred to the holders of stockcompensation awards, in the form of areduction in the exercise price of theawards. This feature is not a participatoryright because the award does not repre-sent a nonforfeitable right to participate inearnings absent the exercise of the award—that is, a right to dividends or dividendequivalents in the form of a reduction inthe exercise price is a contingent transferof value. Similarly, if payment of dividendsor dividend equivalents is contingentupon vesting in the stock compensationaward, the awards are not considered par-ticipating securities.

DisclosuresFSP EITF 03-6-1 requires the presenta-

tion of basic and diluted EPS only for eachclass of common stock and not for partic-ipating securities; however, the guidancedoes not preclude the presentation of basicand diluted EPS for participating securities(e.g., stock compensation awards) as a noteto the financial statements. For example,Helmerich & Payne Inc., in its Form 10-Q filed for the period ended March 31,2012, made the following disclosureregarding the calculation of EPS underthe two-class method:

Accounting Standards Codification(“ASC”) 260, Earnings per Share,requires companies to treat unvestedshare-based payment awards that havenon-forfeitable rights to dividend or div-idend equivalents as a separate class ofsecurities in calculating earnings pershare. We have granted and expect tocontinue to grant restricted stock grants

to employees that contain non-forfeitablerights to dividends. Such grants are con-sidered participating securities underASC 260. As such, we are required toinclude these grants in the calculation ofour basic earnings per share and calcu-late basic earnings per share using thetwo-class method. The two-class methodof computing earnings per share is anearnings allocation formula that deter-mines earnings per share for each classof common stock and participating secu-rity according to dividends declared (oraccumulated) and participation rights inundistributed earnings.Basic earnings per share is computed uti-lizing the two-class method and is cal-culated based on weighted-average num-ber of common shares outstanding dur-ing the periods presented.Diluted earnings per share is computedusing the weighted-average number ofcommon and common equivalent sharesoutstanding during the periods utilizingthe two-class method for stock optionsand nonvested restricted stock (http://www.sec.gov/Archives/edgar/data/4676/000110465912032962/a125931_110q.htm).Exhibit 2 replicates Helmerich & Payne’s

computation of basic and diluted EPS.

Practical ImpactEPS is one of the most common and

complex performance measurements cal-culated by publicly held companies. Certaincompanies issue stock compensationawards that contain rights to receive non-forfeitable dividends prior to thoseawards being vested. These stock com-pensation awards could be considered par-ticipating securities and thus could beincluded in a company’s calculation ofbasic and diluted EPS—yet the inclusionof any provision that contains rights toreceive nonforfeitable dividends prior toawards being vested might have a negativeimpact on a company’s calculation of itsbasic and diluted EPS. The frameworkfor calculating EPS using the two-classmethod described above can be helpful toCPAs facing such a scenario. ❑

Josef Rashty, CPA, has held several man-agerial positions with publicly held tech-nology companies in the Silicon Valleyregion of California. He can be reachedat jrashty@sfsu.edu.

The inclusion of any provision

that contains rights to receive non-

forfeitable dividends prior to awards

being vested might have a negative

impact on a company’s calculation

of its basic and diluted EPS.