Current practice issue
Participating securities and the two-class method of computing EPS
The two-class method is an earnings allocation formula that divides earnings between common stock and any participating securities to the extent that each security would share in earnings as though all earnings for the period had been distributed, even if all earnings might not be distributable for contractual or other reasons.
Companies may have multiple classes of common stock with different dividend participation rights or may have securities that participate in undistributed earnings with common stock. Such instruments are considered "participating securities" under GAAP. Examples of participating securities include certain preferred shares, warrants, restricted stock units, employee stock options, master limited partnership interests, and other instruments, as long as they would share in undistributed earnings in their current form prior to exercise or settlement. An objective of earnings-per-share (EPS) disclosures is to present basic and diluted income available to common shareholders, and when participating securities exist, the two-class method is required to calculate those amounts. For example, assume that a company issues warrants to acquire common stock and that warrant holders would receive the same per-share dividends as common stockholders. Also assume for ease of calculation that an equal number of warrants and common shares are outstanding for the period. Because the warrants are participating securities, income available to common shares (numerator) is reduced by 50 percent in the basic EPS calculation.
Determining how and to what extent participating securities share in earnings can be complex depending on the terms, for example, whether dividends are shared equally or are subject to limitations, among other factors. Further, participating securities classified as assets/liabilities might impact current-period net income.
Basic EPS can be relatively straightforward under the two-class method, as shown above, where earnings are allocated to instruments in their current form. Diluted EPS, however, can present challenges in determining the dilutive impact of participating securities, in part because they can impact both the numerator and denominator. The two-class method does not supersede the if-converted or treasury stock methods for diluted EPS, but requires a company to determine the more dilutive of either the two-class method of earnings allocation or the appropriate if-converted or treasury stock method. For example, in computing diluted EPS, participating convertible preferred stock would be evaluated under both the two-class method, assuming the preferred stock is not converted during the period, as well as the if-converted method. Likewise, participating warrants would be evaluated under both the two-class method, assuming the warrants are not exercised during the current period, as well as the treasury stock method. Liability-classified warrants with an...