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 income statement charge or credit for the period may impact the numerator when applying the treasury stock method. In each case, the more dilutive result for each participating security would be factored into the diluted EPS calculation, along with any other potential common shares from other instruments.

FASB

All decisions reached at Board meetings are tentative and may be changed at future meetings. Decisions are included in an Exposure Draft only after a formal written ballot. Decisions reflected in Exposure Drafts are often changed in redeliberations by the Board based on information received in comment letters, at public roundtable discussions, and from other sources. Board decisions become final after a formal written ballot to issue a final Accounting Standards Update.

EITF consensuses-for-exposure issued for public comment

The FASB recently released two proposed Accounting Standards Updates (ASUs) for public comment:

  • Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes (a consensus of the FASB Emerging Issues Task Force) (EITF Issue 13-A)

  • Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward or Tax Credit Carryforward Exists (a consensus of the FASB Emerging Issues Task Force) (EITF Issue 13-C)

The comment period for both of these proposed ASUs ends April 22, 2013.

Please refer to the January 22 edition of On the Horizon for more information about these proposed ASUs.

Meetings held February 20

The FASB held a joint meeting with the IASB on February 20 to discuss the Boards' projects on revenue recognition and leases. The FASB also held a FASB-only meeting on February 20 to discuss its project on insurance contracts. Highlights of these meetings are discussed below.

Revenue recognition

The IASB and the FASB continued their joint discussions on the revised Exposure Draft, Revenue from Contracts with Customers (the 2011 ED), focusing on disclosures and on transition and effective date guidance.

Disclosures

The Boards reached tentative decisions with respect to the following disclosure areas.

Disaggregation of revenue

  • Retain the proposed requirement to disaggregate revenue

  • Add a requirement to explain how disaggregated revenue information correlates with its reportable segments

Reconciliation of contract balances

  • Replace the proposed requirement to reconcile the contract balances with a combination of quantitative and qualitative disclosures, including the opening and closing balances of contract assets, contract liabilities, and receivables from contracts with customers (if not presented separately) and a description of significant changes in contract assets and liabilities

  • Require disclosure of revenue recognized in the period that arises from amounts allocated to performance obligations satisfied (or partially satisfied) in previous periods (for example, as a result of changes in transaction price or estimates related to the constraint on revenue recognized)

Remaining performance obligations

  • Retain the requirement to disclose information related to the remaining performance obligations

  • Clarify that disclosure of significant payment terms relating to an entity's performance obligations would include a qualitative discussion about any significant variable consideration that was not included in the disclosure of remaining performance obligations

Contract costs

  • Replace the proposed requirement to reconcile the opening and closing balances of assets recognized from the costs incurred to obtain or fulfill a contract with a customer, with a combination of quantitative and qualitative disclosures

Qualitative information about performance obligations

  • Retain the qualitative disclosures about performance obligations and significant judgments

  • Require certain additional qualitative disclosures, including a description of the methods and assumptions an entity uses to determine the amount of revenue constrained

Interim requirements

  • Retain the proposal in the 2011 ED to amend FASB Accounting Standards Codification® (ASC) 270, Interim Reporting, to require an entity to provide certain quantitative disclosures in its interim financial statements, including disaggregated revenue and opening and closing balances of contract assets and contract liabilities (FASB only)

  • Amend International Accounting Standard (IAS) 34, Interim Financial Reporting, to require an entity to disaggregate revenue in its interim financial statements in accordance with the 2011 ED (IASB only)

Transition and effective date

The Boards tentatively decided that the proposed guidance would be effective for reporting periods beginning on or after January 1, 2017. Early adoption would not be permitted.

Entities would be permitted to apply the new revenue standard either retrospectively subject to some practical expedients or through an alternative transition method. The alternative transition method would require an entity to apply the proposed guidance only to contracts not completed under existing U.S. GAAP at the date of initial application and to recognize the cumulative effect of adoption as an adjustment to the opening balance of retained earnings in the year of initial application. An entity that chooses to apply the alternative transition method would not restate comparative years; however, it would be required to provide the following additional disclosures in the initial year of adoption:

  • By income statement line item, the current-year impact of applying the new revenue standard

  • An explanation of the significant changes between the reported results under legacy U.S. GAAP and the new revenue standard

Next steps

The Boards have completed their substantive redeliberations of the 2011 ED, and the staff will begin drafting the final revenue standard, which is expected to be issued in the middle of 2013.

Leases

The Boards tentatively decided to provide specific transition relief for existing finance, capital, sales-type, and direct financing leases. At transition to the new guidance, lessees and lessors would not be required to make any adjustments to the carrying amount of any assets and liabilities associated with those leases. The revised Exposure Draft on leases will include specific guidance on the subsequent measurement of those assets and liabilities. The Boards' intent for including that guidance is to provide accounting that is consistent with how most of those leases would be accounted for under ASC 840, Leases, and IAS 17, Leases.

The FASB discussed the transition for leveraged leases and tentatively decided that a lessor would retrospectively apply the proposed guidance for leases to existing leveraged leases.

Insurance contracts

The following highlights are from the FASB-only discussions of the proposed guidance on accounting for insurance contracts.

Segregated assets related to direct performance-linked insurance contracts

The Board discussed segregated assets related to direct performance-linked insurance contracts and reached the following tentative decisions:

  • The liability for "direct performance linked insurance contracts" and the assets directly linked to those liabilities would be reported in the insurer's financial statements.

  • Specified guidance would apply if the segregated fund arrangement meets certain conditions.

Accretion of interest on the margin

The Board tentatively decided that in order to reflect the time value of money, an insurer would accrete interest on the margin. The rates used to accrete the interest would be based on the same yield curves used for purposes of discounting the cash flows determined at the inception of the portfolio of insurance contracts, and they would not be subsequently adjusted.

SEC

Staff overview issued on foreign private issuers

The overview described below reflects the views of the staff of the Division of Corporation Finance. It is not a Commission statement and the Commission has neither approved nor disapproved its contents. It is not intended to provide legal advice of the Commission or the staff and is not a substitute for, and may not be relied on instead of, the federal securities laws, the Commission's regulations and forms, and the advice of knowledgeable advisors.

The SEC staff recently issued Accessing the U.S. Capital Markets ‒ A Brief Overview for Foreign Private Issuers, which provides a general outline of several U.S. federal securities law issues that apply to foreign private issuers (FPIs). The staff overview includes additional matters of importance to FPIs considering a listing on U.S. capital markets.

The staff overview outlines the following considerations for FPIs planning to raise capital or establish a presence for their securities in the United States:

  • Conducting a registered offering under the Securities Act of 1933 (Securities Act)

  • Conducting an offering exempt from registration under the Securities Act

  • Registering a class or classes of securities under the Securities Exchange Act of 1934 (Exchange Act)

  • Establishing and maintaining exemptions from registration under the Exchange Act

  • Meeting reporting obligations under the Exchange Act

  • Establishing an American Depositary Receipt program

The overview does not address special regulatory provisions, including special regulations applicable to blank check or shell companies, and the rules applicable to cross-border rights offers, tender offers, exchange offers, or business combinations.

SEC announces 2013 examination priorities

The SEC recently published its Examination Priorities for 2013, which covers various issues at financial institutions, including broker-dealers, clearing agencies, exchanges and self-regulatory organizations, investment companies, hedge funds and private equity funds, and transfer agents. The SEC's objective in publishing these priorities is (a) to support its mission to protect investors and to maintain fair, orderly, and efficient markets, (b) to communicate with investors and registrants about areas that are perceived to have heightened risk, and (c) to facilitate capital formation.

These priorities address issues that are pervasive to all registrants, as well as issues specific to particular business models and organizations. The examination priorities that apply to nearly all registrants include fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and technology controls. In addition, there are four program areas that focus on specific priorities for investment advisers and investment companies, broker-dealers, market oversight, and clearing and settlement.

The examination priority list is not exhaustive, and priorities may be adjusted throughout the year in light of ongoing risk-assessment activities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.