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Earnings per share for ESOP convertible preferred stock.


This month's column continues the discussion of employee stock ownership plan-related issues on which the Financial Accounting Standards Board emerging issues task force (EITF) recently reached consensus. Here we address certain earnings-per-share questions related to convertible preferred stock held by an ESOP.

EITF Abstracts, copyrighted by the FASB, is available in soft-cover and loose-leaf versions and may be obtained by contacting the FASB order department at 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116.

ISSUE NO. 89-12

Background. Accounting Principles Board Opinion no. 15, Earnings per Share, requires public companies to present earnings-per-share (EPS) data on the face of the income statement. Generally, the EPS computation is based on the common stock outstanding during the period and any common stock equivalents.

A common stock equivalent is a security that, because of the terms under which it was issued, is in substance the same as common stock. These include stock options, warrants, contingent shares and certain convertible securities.

Convertible securities are included in EPS computations using the if-converted method. Under that method, the security is assumed to have been converted into common stock at the beginning of the period, or at issuance, if later. Conversion is assumed if the convertible security is a common stock equivalent and the assumed conversion reduces EPS. Dividends on convertible preferred stock are taken into account to determine income that's applicable to common stock.

AICPA Statement of Position (SOP) no. 76-3, Accounting Practices for Certain Employee Stock Ownership Plans, is the only existing authoritative literature on the accounting for ESOPs. At the time the SOP was issued, ESOPs were not being structured as they are now. The convertible preferred leveraged ESOP apparently is becoming the predominant form of new ESOPs. Accounting practice for such ESOPs is diverse.

The facts. The EITF considered the following situation: An employer issues convertible preferred stock to an ESOP. The ESOP finances the purchase of those securities with debt that is serviced by both employer contributions and dividends on the stock.

The employer may redeem the preferred stock with cash or common stock at a price equal to the initial value of the preferred stock. The employer also may guarantee the plan participants will receive at least the redemption price of the preferred stock when they leave the company.

Accounting issues. The task force considered four related accounting issues.

Issue 1: Are the convertible preferred shares issued to an ESOP considered common stock equivalents?

Consensus: The task force concluded the convertible preferred stock would not be considered a common stock equivalent unless the yield on the issue date is less than 66 2/3% of the corporate Aa bond rate.

This is the test adopted by the FASB in Statement no. 85, Yield Test for Determining Whether a Convertible Security Is a Common Stock Equivalent, and is consistent with the APB's objective in Opinion no. 15 to include securities that have a yield to the holder significantly below the yield of a similar security without the conversion option.

Issue 2: To calculate EPS under the if-converted method, should net income be reduced by the additional ESOP contribution necessary to meet the debt service requirement? (Under that method, preferred stock dividends no longer would be available to meet the debt service because the preferred stock is assumed to be converted.)

Consensus: The task force concluded net income should be adjusted by the difference between the current preferred dividend and the dividends on the common stock considered outstanding.

Issue 3: If the employer guarantees a minimum redemption value for the preferred stock, should the number of shares assumed to be outstanding increase if the common stock's market price falls below the preferred stock's redemption price?

Consensus: The task force concluded, in accordance with paragraph 63 of Opinion no. 15, if the market price of the underlying common stock is less than the guaranteed value of the preferred stock, the calculation should reflect the number of shares assumed to be issued based on market price at period's end.

Prior-period EPS data should be restated if the number of shares issued or contingently issuable subsequently changed because of changes in the market price.

Issue 4: Would the answer in issue 3 change if the redemption price guarantee could be satisfied by paying cash?

Consensus: Yes. The task force decided if the employer is either (a) required to or (b) has the ability and expressed intent to satisfy the guarantee feature in cash, no additional issuance of shares is assumed in the calculation. The stated conversion rate should be used for all shares.

Other conclusions. The consensuses apply regardless of how the convertible preferred stock is classified on the balance sheet.

The consensuses on issues 2, 3 and 4 apply to both primary and fully diluted EPS calculations if the convertible preferred stock is a common stock equivalent.


The Securities and Exchange Commission Observer said registrants must retroactively apply these consensuses for all periods presented in financial statements filed with the SEC after the date the consensuses were reached. (Issue 2 was decided on June 29, 1989; issues 1, 3 and 4 were decided on December 14, 1989.)

The SEC observer emphasized the conclusions reached on these ESOP issues should not be used for other EPS situations.

JOHN GRAVES, CPA, director-technical services, and MOSHE S. LEVITIN, CPA, technical manager, of the American Institute of CPAs technical information division.
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Publication:Journal of Accountancy
Date:Apr 1, 1990
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