Treasury stock method under ASC 260 and IAS 33: how options dilute EPS
Under ASC 260, the treasury stock method assumes that every in-the-money option, warrant and unvested restricted stock unit is exercised at the start of the period, and that the cash the company would receive is used to buy back its own common stock at the average market price for the period. Only the net shares that remain after that hypothetical buyback enter the diluted EPS denominator. IAS 33 Earnings per Share reaches the same result without using the label: it splits each option into a sale of shares at the average market price and an issue of the remaining shares for no consideration, and only the shares issued for no consideration are dilutive.
The arithmetic is identical under both frameworks for a single annual period. The differences sit in the details that drive the reported number: what counts as assumed proceeds, how unrecognized compensation cost for unvested awards is treated, and how the year-to-date figure is built from quarterly calculations. On year-to-date reporting, US GAAP and IFRS can produce different share counts from the same option book, because ASC 260 averages the quarterly incremental shares while IAS 33 requires dilutive potential shares to be determined independently for each period presented.
For a company with a material equity plan, the treasury stock method is the main bridge between the share-based payment ledger and the per-share figures that analysts, lenders and compensation committees track. The general mechanics of basic and diluted EPS are covered in our article on earnings per share computation; the focus here is the option and RSU calculation itself, with a full worked example.
··········
HOW THE TREASURY STOCK METHOD WORKS UNDER ASC 260.
ASC 260 Earnings per Share requires diluted EPS to reflect potential common shares from options, warrants and similar instruments using the treasury stock method. The calculation has three steps. The company assumes exercise of the instrument at the beginning of the period, or at the issue date if later. It assumes that the proceeds from exercise are used to purchase common stock at the average market price during the period. The difference between the shares assumed issued and the shares assumed repurchased is added to the weighted average shares outstanding in the denominator.
Options and warrants have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price. An option whose exercise price is above the average market price would, in theory, let the company buy back more shares than it issues, which would increase EPS. Those instruments are antidilutive and are excluded from the calculation, although they remain outstanding and must be disclosed.
For share-based payment awards, assumed proceeds include more than the cash exercise price. They also include the average unrecognized compensation cost for future service that has not yet been recognized as expense. For a restricted stock unit with no exercise price, the unrecognized compensation cost is the only component of assumed proceeds, so an RSU with remaining service still produces a buyback offset in the calculation. Since the amendments in ASU 2016-09, excess tax benefits are no longer part of assumed proceeds, because those tax effects now run through income tax expense instead of additional paid-in capital.
The control number for the dilution test is income from continuing operations. When a company reports a loss from continuing operations, no potential common shares are included in diluted EPS, because adding shares would reduce the loss per share. In that case diluted and basic loss per share are the same amount even if the option book is deep in the money.
··········
HOW IAS 33 MEASURES THE DILUTIVE EFFECT OF OPTIONS AND WARRANTS.
IAS 33 requires an entity to assume the exercise of dilutive options and warrants. The assumed proceeds are regarded as received from the issue of ordinary shares at the average market price during the period, and the difference between the number of shares issued and the number that would have been issued at the average market price is treated as an issue of ordinary shares for no consideration. Options and warrants are dilutive when they would result in the issue of ordinary shares for less than the average market price.
The standard applies the same in-the-money condition as ASC 260: options and warrants have a dilutive effect only when the average market price of ordinary shares during the period exceeds the exercise price. Antidilutive instruments are left out of the calculation, and IAS 33 requires instruments excluded on that basis to be disclosed.
For share options and other share-based payment arrangements within the scope of IFRS 2, IAS 33 paragraph 47A provides that the issue price and the exercise price include the fair value of any goods or services to be supplied to the entity in the future under the arrangement. This is the IFRS counterpart of unrecognized compensation cost in the US GAAP calculation. IAS 33 paragraph 48 treats employee share options with fixed or determinable terms and non-vested ordinary shares as options for diluted EPS, even though they may be contingent on vesting, while performance-based employee share options are treated as contingently issuable shares.
IAS 33 also sets the order in which potential shares are tested. Each issue or series of potential ordinary shares is considered in sequence from the most dilutive to the least dilutive, and the dilution test uses profit or loss from continuing operations attributable to the parent as the control number. Options and warrants are normally included first because they do not adjust the numerator.
··········
TREASURY STOCK METHOD: ASC 260 VS IAS 33 COMPARISON.
The two standards share the same model for a single period, and most of the practical differences come from interim reporting and from the scope of instruments covered by each calculation. The table below sets out the main points.
........
Point | ASC 260 (US GAAP) | IAS 33 (IFRS) |
Name of the method | Treasury stock method | Shares issued for no consideration |
Price for the buyback | Average market price for the period | Average market price for the period |
Dilutive only if | Average price exceeds exercise price | Average price exceeds exercise price |
Unvested awards | Unrecognized compensation cost added to proceeds | Fair value of future services added to proceeds |
Excess tax benefits | Excluded from proceeds | Not part of the model |
Year-to-date diluted EPS | Weighted average of quarterly incremental shares | Determined independently for each period |
Control number | Income from continuing operations | Profit or loss from continuing operations |
Antidilutive instruments | Excluded, disclosed | Excluded, disclosed |
........
The year-to-date difference has a direct effect on the share count in annual and nine-month reporting, and the worked example below shows its size on a realistic option book.
··········
WORKED EXAMPLE: DILUTED EPS WITH OPTIONS AND RSUS.
The following figures are illustrative. A company reports net income of $12,000,000 for the year, with no preferred stock and no discontinued operations, and 10,000,000 weighted average common shares outstanding. The average market price of its common stock for the year is $40.00. Its equity plan includes four groups of awards, all outstanding for the full year.
........
Award group | Units | Exercise price | Unrecognized cost per unit |
A: vested options | 600,000 | $25.00 | $0.00 |
B: vested options | 400,000 | $45.00 | $0.00 |
C: unvested options | 200,000 | $30.00 | $5.00 |
D: unvested RSUs | 300,000 | $0.00 | $20.00 |
........
The unrecognized cost column is the average unrecognized compensation cost for the year, per unit. For the RSUs it represents $6,000,000 of average unrecognized cost across 300,000 units. Each group is tested separately, and the incremental shares are computed as units minus assumed proceeds divided by the $40.00 average price.
........
Award group | Assumed proceeds | Shares repurchased | Incremental shares |
A | $15,000,000 | 375,000 | 225,000 |
B | $18,000,000 | 450,000 | 0 (antidilutive) |
C | $7,000,000 | 175,000 | 25,000 |
D | $6,000,000 | 150,000 | 150,000 |
Total | 400,000 |
........
Group B is out of the money at the average price, since $45.00 is above $40.00, so it is excluded and disclosed as antidilutive. Group C shows the effect of unrecognized compensation cost. On the cash exercise price alone the company would be assumed to repurchase 150,000 shares and add 50,000; including the $1,000,000 of unrecognized cost raises the buyback to 175,000 shares and cuts the incremental shares to 25,000.
Basic EPS is $12,000,000 divided by 10,000,000 shares, or $1.20. The diluted denominator is 10,000,000 plus 400,000 incremental shares, or 10,400,000, and diluted EPS is $12,000,000 divided by 10,400,000, or $1.15 (1.1538 before rounding). The same result applies under IAS 33 for the annual period, because the inputs and the formula are the same.
··········
YEAR-TO-DATE DILUTED EPS: QUARTERLY AVERAGING UNDER ASC 260.
The year-to-date rule changes the answer when the share price moves during the year. Assume the quarterly average prices for the same company were $30.00, $36.00, $44.00 and $50.00, and that the annual average of $40.00 equals the simple mean of those four figures. Groups A and B are recomputed for each quarter.
........
Quarter | Average price | Group A incremental | Group B incremental | Total |
Q1 | $30.00 | 100,000 | 0 | 100,000 |
Q2 | $36.00 | 183,333 | 0 | 183,333 |
Q3 | $44.00 | 259,091 | 0 | 259,091 |
Q4 | $50.00 | 300,000 | 40,000 | 340,000 |
........
Under ASC 260, the incremental shares included in year-to-date diluted EPS are the year-to-date weighted average of the incremental shares included in each quarterly computation. With equal quarters, group A contributes 210,606 shares and group B contributes 10,000 shares, for 220,606 in total. Group B enters the annual figure even though the annual average price of $40.00 is below its $45.00 exercise price, because it was dilutive in the fourth quarter.
Under IAS 33, dilutive potential ordinary shares are determined independently for each period presented, so the annual figure is computed on the annual average price. Group A contributes 225,000 shares and group B contributes nothing, for 225,000 in total. The gap of 4,394 shares is small in this example, but the direction and size depend on the price path and on how many awards sit close to the money.
··········
JOURNAL ENTRIES BEHIND THE OPTION AND RSU BALANCES.
The treasury stock method is a memo calculation and generates no journal entry. The entries that feed it are the compensation cost and the settlement of the awards, recorded under ASC 718 and IFRS 2. For the background on measurement and attribution of these awards, see our article on share-based payment transactions under IFRS 2 and ASC 718.
Assume the RSUs in group D had a grant-date fair value of $35.00 per unit, or $10,500,000 in total, with four-year cliff vesting, and that the group A options had a grant-date fair value of $8.00 per option. The common stock has a par value of $0.01. The illustrative entries are the annual RSU expense, the exercise of all group A options, and the eventual vesting of the RSUs.
........
Entry | Account | Debit | Credit |
1. Annual RSU expense | Compensation expense | $2,625,000 | |
APIC, stock compensation | $2,625,000 | ||
2. Exercise of group A | Cash | $15,000,000 | |
APIC, stock options | $4,800,000 | ||
Common stock, par | $6,000 | ||
APIC, common stock | $19,794,000 | ||
3. Vesting of group D | APIC, stock compensation | $10,500,000 | |
Common stock, par | $3,000 | ||
APIC, common stock | $10,497,000 |
........
Entry 2 shows why the treasury stock method uses the exercise price as the main source of proceeds: the $15,000,000 of cash is what the company would hypothetically use to buy back shares. After exercise, the 600,000 shares are part of basic weighted average shares from the exercise date, and they leave the incremental share calculation. Income tax entries on the awards are omitted; their measurement differs between ASC 740 and IAS 12, and tax deductions that differ from book expense are handled outside the EPS calculation.
··········
PRESENTATION AND DISCLOSURE OF DILUTED EPS.
Both standards require basic and diluted EPS on the face of the income statement for each period presented, with a reconciliation of the numerators and denominators. The reconciliation shows the incremental shares from options, warrants and RSUs as a separate line, which is where the treasury stock method result becomes visible to readers.
The disclosure of antidilutive instruments carries information in its own right. In the example, the 400,000 group B options would be disclosed as excluded from diluted EPS for the year under IAS 33, while under ASC 260 the year-to-date calculation includes part of their effect through the fourth quarter. Companies that also issue warrants should check classification first, because liability-classified warrants follow a different path through the numerator; the classification rules are covered in our article on warrant classification under ASC 815-40 and IAS 32.
Convertible instruments do not use the treasury stock method under either framework. ASU 2020-06 requires the if-converted method for convertible instruments under US GAAP, and IAS 33 reflects convertible instruments through the if-converted approach as well, adjusting both numerator and denominator. Employee stock purchase plans with a look-back feature are another source of potential shares, discussed in our article on ESPP accounting under ASC 718 and IFRS 2.
··········
COMMON ERRORS IN TREASURY STOCK METHOD CALCULATIONS.
A frequent error is using the period-end share price instead of the average market price. The period-end price is relevant for some contingently issuable share tests, but the treasury stock method buyback uses the average for the period. A related error is applying one annual average to all quarters, which overstates or understates the year-to-date share count under ASC 260 when prices rise or fall during the year.
A second group of errors concerns assumed proceeds. Leaving out unrecognized compensation cost overstates dilution for unvested options and RSUs; in group C it would double the incremental shares from 25,000 to 50,000. Including excess tax benefits in proceeds is a holdover from the rules before ASU 2016-09. Treating RSUs as fully dilutive with no buyback offset ignores the unrecognized cost component.
A third group concerns scope. Options granted or cancelled during the period are included only for the time they were outstanding. Performance-based awards are tested as contingently issuable shares and enter the calculation only if the conditions would be met at the reporting date. Antidilution is tested against income from continuing operations, so a company with a loss from continuing operations but net income after discontinued operations still reports no dilution.
··········
TREASURY STOCK METHOD CHECKLIST FOR ASC 260 AND IAS 33.
Confirm the average market price for each quarter and for the year from a consistent source, and document how the average is computed. List every option, warrant and RSU grant with its exercise price, units outstanding, dates outstanding during the period and average unrecognized compensation cost. Test each grant separately for dilution and exclude those whose exercise price exceeds the average price, keeping a list for the antidilution disclosure.
Compute the incremental shares by quarter and build the US GAAP year-to-date figure as the weighted average of the quarterly results; for IFRS reporting, compute the year-to-date and annual figures independently on the average price for each period. Reconcile the incremental share count with the equity roll-forward for the period, check that exercised awards moved from incremental shares into basic shares at the exercise date, and confirm the control number before including any potential shares.
The treasury stock method itself is mechanical under ASC 260 and IAS 33 once the inputs are right. The judgement sits in the inputs: the average price data, the unrecognized compensation cost per award, the classification of performance awards as contingently issuable, and for dual reporters, the separate year-to-date calculations that the two standards require.
··········
FOLLOW US FOR MORE.
·····
DATA STUDIOS
·····
datastudios.org
