FSP EITF 03-6-1 - Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities

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By: Linda Cavanaugh, CPA FSP EITF 03-6-1 (FSP) is effective for fiscal years beginning after December 15, 2008 and is to be applied retrospectively. This means that all comparative data has to be shown as if this FSP was in effective from the beginning.

This FSP requires share based compensation awards that qualify as participating securities to be included in basic EPS using the two-class method. A share based compensation award is considered a participating security if it receives non-forfeitable dividends. A non-forfeitable dividend would be a dividend that the participant receives before the award is vested and if the participant forfeits the actual shares awarded the dividends he/she has received do not have to be paid back to the company. In other words, once they get the money they don’t have to return it regardless of what happens to the actual shares under the award.

Paragraph 6 of the FSP states that “unvested share based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method.” I think the unpaid part is important. Sometimes the dividends are used to buy more shares instead of giving them in cash to the participant. These dividends are still included in this calculation if the company would have to give them that cash if the shares are forfeited.

Another interested catch is the dividends on shares that are not expected to vest. FAS 123R requires a company to estimate the forfeiture rate of an award at the beginning and on an ongoing basis. For the shares that are not expected to vest, the dividends are considered additional compensation expense and are recorded in earnings instead of an equity account. These dividends are not included in the calculation of EPS, but the shares are still included in the denominator.

If the dividends are transferred to the participant as a reduction to the exercise price of the award, the dividends are not considered non-forfeitable and the shares would not be considered participating securities.

Paragraph 1 of the FSP states that the participating securities should be “included in the earnings allocation in computing EPS under the two-class method described in paragraphs 60 and 61 of FAS 128.”

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.”

Step 1. Starting with income from continuing operations, reduce income from continuing operations by the amount of dividends declared in the current period for each class of stock. The remaining income from continuing operations is considered “Undistributed Earnings”.

Net Income $100,000
Dividends on Common Stock (10,000 shares) (10,000)
Dividends on Participating
Securities (5,000 shares) (5,000)
Undistributed Earnings $ 85,000

Step 2. The undistributed earnings are allocated to common stock and participating securities on a percentage basis. This amount is then divided by the number of shares in each category. (i.e. common stock outstanding and participating securities.)

Common Stock
(10,000/15,000) * $85,000 = $56,667/10,000 = $5.67 EPS on common stock

Participating Securities
(5,000/15,000) * $85,000 = $28,333/5,000 = $5.67 EPS on participating securities

Step 3. The dividends paid to the participating securities is divided by the number of participating securities and the dividends paid to the rest of the common stockholders is divided by the number of common stock outstanding.

Common Stock
$10,000/10,000 = $1 EPS on common stock

Participating Security
$5,000/5,000 = $1 EPS on Participating Security

Step 4. The amount allocated to each category is then added together to obtain the EPS for that category.

Common Stock
$5.67 + $1.00 = $6.67 EPS on common stock

Participating Security
$5.67 + $1.00 = $6.67 EPS on Participating Security

In comparison EPS before the FSP would have been:

$100,000/10,000 = $10 EPS on common stock

Basic and diluted EPS data is to be presented for each class of common stock but the EPS for the restricted shares does not have to be presented. However, neither FAS 128 nor the FSP disallows the presentation of the EPS for participating securities. This means while you have to go through the calculation process, you do not have to present the EPS for the participating securites on the income statement with the other EPS data.

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