The Two-Class Method for EPS: Theory, Rule, and Implementation

By Nathan Slavin and Steven Petra

E-mail Story Print Story

The capital structures of some companies include securities that may share in a company’s earnings with common stock (i.e., participating securities). EITF 03-6 defines a participating security as “a security that may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not.” Participation does not have to be in the form of a dividend; any form of participation in undistributed earnings would constitute participation. Typically, such securities share in the undistributed earnings of a company through a formula tied to the dividends paid on common stock. For example, a warrant entitling the holder to a “yield right” equal to 20% of the dividends paid on common stock would be a participating security, even though the yield right was not labeled a dividend. Participating securities may or may not be convertible into common stock.

The computation and presentation of EPS by publicly traded companies are governed by SFAS 128. The standard requires the presentation of basic EPS for those companies with a simple capital structure (i.e., only common stock outstanding) and the dual presentation of basic EPS and diluted EPS for companies with a complex capital structure (i.e., common stock and potentially dilutive securities outstanding). SFAS 128 requires using the if-converted method for those participating securities that are convertible into common stock if the effect is dilutive. For those participating securities that are not convertible into common stock, the two-class method of computing EPS is prescribed.

The two-class method of computing EPS is an earnings allocation formula that determines EPS for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. The following explanation of the two-class method is contained in SFAS 128:

a. Income from continuing operations (or net income) shall be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends (or interest on participating income bonds) that must be paid for the current period (for example, unpaid cumulative dividends).
b. The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to each security shall be determined by adding together the amount allocated for dividends and the amount allocated for a participation feature.
c. The total earnings allocated to each security shall be divided by the number of outstanding shares of the security to which the earnings are allocated to determine the earnings per share for the security.
d. Basic and diluted EPS data shall be presented for each class of common stock.

For the diluted EPS computation, outstanding common shares includes all potential common shares assumed issued. EITF 03-6 has also significantly clarified and narrowed how the two-class method is to be applied in the computation of basic EPS. Prior to the release, some ambiguity was present regarding what constituted a participating security and how the two-class method should be applied to a reported operating loss.

Illustration: The Two-Class Method

Aspect Communications Corporation elected to use the two-class method in calculating basic EPS. The following information was contained in their financial statements for the year ended December 31, 2003:

• Net income was $36,725,000.
• 54,453,000 shares of $.01 par value common stock were outstanding (weighted average).
• 50,000 shares of $.01 par value redeemable convertible preferred stock were outstanding.
• The common stock did not receive a dividend.
• The preferred stock received a dividend in the amount of $7,700,000.
• The preferred stock was convertible into 20,926,000 shares of common stock (weighted average) and contained certain participation rights. These participation rights entitled the preferred stockholders to participate, on an if-converted basis, in dividends declared on common stock.

Exhibit 1 shows the computation of basic EPS for 2002 using the two-class method. Aspect Communications reported basic EPS of $0.39 on the face of its income statement. The presentation of basic EPS for preferred stock of $316.54 is for illustrative purposes only, and was not presented by the company (though it was not precluded from doing so).

Discussion

SFAS 128 did not clearly indicate whether the if-converted method was required for participating convertible securities in calculating both basic and diluted EPS. In an attempt to clarify this issue, the FASB staff issued, in April 2001, EITF Topic D-95, “Effect of Participating Convertible Securities on the Computation of Basic Earnings Per Share.” Topic D-95 required participating convertible securities to be included in the computation of basic EPS if the effect is dilutive. The manner in which participating convertible securities should be included in the computation of basic EPS was left under Topic D-95 as an accounting policy decision, leaving the use of either the if-converted method or the two-class method up to the discretion of management. Nonetheless, under Topic D-95, the dilutive effect on basic EPS of such participating convertible securities cannot be less than that which would result from the application of the two-class method that would be required if the same security were not convertible. With the issuance of EITF 03-6, Topic D-95’s allowance of the if-converted method has been superseded, and the two-class method is now mandatory.

Illustration: The If-Converted Method

The R.H. Donnelley Corporation elected to use the if-converted method in calculating basic EPS. The following information was contained in their financial statements for the year ended December 31, 2002:

• Net income was $67,177,000.
• 29,643,000 shares of common stock were outstanding (weighted average).
• 70,000 shares of redeemable convertible preferred stock were outstanding.
• The preferred stock dividend was $24,702,000.
• The preferred stock was convertible into 281,000 shares of common stock (weighted average) and contained participation rights that entitled the preferred stockholders to participate, on an if-converted basis, in dividends declared on common stock.

Basic EPS for 2002 using the if-converted method is computed in Exhibit 2.

Resolution of Other Issues

Additional issues remained unresolved, however, and in March 2004 the EITF reached a consensus on these issues, which are identified in EITF Issue 03-6 as follows:

Issue 1: Does the two-class method require the presentation of basic and diluted EPS for all participating securities?

The EITF 03-6 Consensus was that the two-class method does not require the presentation of basic and diluted EPS for all participating securities. If the participating security is another class of common stock, however, EPS must be shown on the income statement for both classes of common stock under SFAS 128. It should be noted that although it is not required, the presentation of basic and diluted EPS for a participating security other than common stock is not prohibited.

Issue 2: How should a participating security that requires application of SFAS 128 be defined?

The EITF 03-6 Consensus was that a participating security is a security that may participate in undistributed earnings with common stock. Any form of participation would constitute participation regardless of whether or not the payment to the security holder was referred to as a dividend.

Issue 2(a): May all potential common shares—that is, securities or other contracts that may entitle their holders to obtain common stock (such as options, warrants, forwards, convertible debt, and convertible preferred stock)—be considered participating securities?

The EITF 03-6 Consensus was that securities or other contracts that may entitle their holders to obtain common stock may be participating securities if they meet the definition of a participating security as set forth in Issue 2, prior to exercise or settlement (that is, in their current form).

Issue 2(b)(i): Do dividends or dividend equivalents paid to the holder of a convertible security that are applied to either reduce the conversion price or increase the conversion ratio of the security represent participation rights?

The EITF 03-6 Consensus was that participation rights do not include dividends or dividend equivalents transferred to the holder of a convertible security in the form of a reduction to the conversion price or an increase in the conversion ratio. Similarly, securities such as options and warrants that call for the issuance of the company’s common stock do not contain participation rights if these securities provide for an adjustment to the exercise price that is tied to the declaration of dividends by the issuer. Nonetheless, a provision in a forward contract to issue an entity’s own shares that reduces the contract price when dividends are declared, does constitute a participation right.

Issue 2(b)(ii): Should an issuing company recognize a dividend equivalent that is applied to reduce the conversion price or increase the conversion ratio of a convertible security in its financial statements? If so, how should those dividend equivalents be recognized in the financial statements?

The EITF 03-6 Consensus was that a dividend equivalent that is applied to reduce the conversion price or increase the conversion ratio of a convertible security should be recognized as a contingent beneficial conversion feature in the financial statement of the issuing company. Such recognition would reduce net income available to common shares in the numerator of the basic EPS calculation and have no effect on the weighted average common shares outstanding in the denominator. The contingent beneficial conversion feature should be recognized in accordance with the guidance contained in Issue 7 of EITF 00-27 in determining how and when to recognize the terms of a contingent conversion option in the financial statements.

Issue 3: How should undistributed earnings be allocated to a participating security?

The EITF 03-6 Consensus was that undistributed earnings for a period should be allocated to a participating security based on objectively determinable, nondiscretionary participation. If the company can avoid distributions to participating security holders, no allocation of undistributed earnings to a participating security should be made.

Participation rights that are contingent on or subject to the discretion of the company should be fully disclosed in accordance with SFAS 129, Disclosure of Information about Capital Structure. To illustrate the application of Issue 3, EITF 03-6 offers the following examples:

Example A: A participating security provides the holder with the ability to participate in all dividends declared with the holders of common stock on a 1:1 per-share basis. Evaluation: The undistributed earnings in this example should be allocated between the common stock and the participating security on a 1:1 per-share basis.

Example B: A participating security provides the holder with the ability to participate with the holders of common stock in dividends declared contingent upon the occurrence of a specified event, the occurrence of which is subject to management discretion or is not objectively determinable (for example, liquidation of the company or management determination of an “extraordinary” dividend). Evaluation: The terms of the participating security in this example do not specify objectively determinable, nondiscretionary participation rights; therefore, undistributed earnings would not be allocated to the participating security.

Example C: A participating security provides the holder with the ability to participate with the holders of common stock in earnings for a period in which a specified event occurs, regardless of whether a dividend is paid during the period (e.g., achievement of a target market price of a security, or achievement of a certain earnings level). Evaluation: In this example, undistributed earnings would be allocated to common stock and the participating security based on the assumption that all of the earnings for the period are distributed. Undistributed earnings would be allocated to the participating security if the contingent condition would have been satisfied at the reporting date, irrespective of whether an actual distribution was made for the period.

Example D: A participating security provides the holder with the ability to participate in extraordinary dividends. The classification of dividends is predetermined by a formula (e.g., any dividend per common share in excess of 5% percent of the current market price is defined as extraordinary). Evaluation: Undistributed earnings would be allocated to common stock and the participating security based on the assumption that all of the earnings for the period are distributed. If earnings for a given period exceed the specified requirements for participation (e.g., earnings for the period are in excess of the predetermined 5% threshold), undistributed earnings would be allocated to the participating security according to its terms.

Example E: A participating security provides the holder with the ability to participate in extraordinary dividends, the classification of which is at the sole discretion of the board of directors. Evaluation: Undistributed earnings would be allocated only to common stock in this example. Because the classification of dividends as extraordinary is within the sole discretion of the board of directors, undistributed earnings would not be allocated to the participating security, as the participation in the undistributed earnings would not be objectively determinable.

Example F: A participating security provides the holder with the ability to participate in all dividends up to a specified threshold (e.g., the security participates in dividends per common share up to 5% of the current market price of the stock). Evaluation: Undistributed earnings would be allocated to common stock and the participating security based on the assumption that all of the earnings for the period are distributed. In this example, undistributed earnings would be allocated to common stock and to the participating security up to 5% of the current market price of the common stock, because the amount of the threshold for participation by the participating security is objectively determinable. The remaining undistributed earnings for the period would be allocated to common stock.

Issue 4: Should a company that allocated undistributed earnings to a nonconvertible participating security continue to do so in a period of net loss if the effect is antidilutive?

The EITF 03-6 Consensus was that a company that allocated undistributed earnings to a nonconvertible participating security should continue to do so in a period of net loss if the participating security has a contractual obligation to share in the losses of the issuing company, even if the effect is antidilutive. The contractual rights and obligations of the participating security, evaluated on a period-by-period basis, would determine whether or not the participating security holder has an obligation to share in the losses of the issuing company.

The EITF specifically identified the following two situations that would constitute a contractual obligation of a participating security to share in the losses of the issuing company and allow allocation of undistributed earnings to the participating security in a period of net loss:

• The participating security holders are obligated to fund the losses of the issuing company, or
• The losses negatively affect the liquidation preference or the return of principal on the participating security.

Issue 5: Will a convertible participating security be excluded from the computation of basic EPS if a company has a net loss from continuing operations?

The EITF 03-6 Consensus was that a company that allocated undistributed earnings to a convertible participating security would continue to do so in a period of net loss if the participating security has a contractual obligation to share in the losses of the issuing company, even if the effect were antidilutive. The basis for the conclusion reached in Issue 4 would also apply to the inclusion of convertible participating securities in basic EPS, irrespective of the differences that might exist between convertible and nonconvertible securities.

The following examples are contained in the EITF Issue Summary and illustrate situations in which participating securities share in the losses of the issuing company, resulting in allocation of undistributed earnings in the computation of basic EPS. The examples assume that Company XYZ was formed on January 1, 2001, and was initially capitalized with 10,000 shares of $50 par value Class A common stock and 5,000 shares of $100 par value Class B common stock. XYZ had a net loss of $100,000 for 2001, net income of $50,000 for 2002, and net income of $75,000 for 2003.

Example G: The Class B common stock participates in dividends declared with the Class A common stock on a 1:1 per share basis and shares equally in Company XYZ’s net assets upon liquidation. The Class B common shareholders are entitled to two votes per share, whereas the Class A shareholders are entitled to one vote per share. Evaluation: Earnings and losses for all three years would be allocated to Class A common shares and the participating Class B common shares, because the Class B shareholders are in essentially the same economic position as the Class A shareholders.

Example H: Assume the same facts as Example G, but in addition to the Class A and Class B common stock, Company XYZ also has 1,000 shares of Series A preferred stock issued and outstanding throughout 2001, 2002, and 2003. The Series A preferred stock has a par value of $1, was sold for $20 per share, has a liquidation preference of $20 per share, and pays cumulative dividends at 3%. The holders of the Series A preferred stock are entitled to one vote per share on all matters upon which holders of Class A and Class B common stock are entitled to vote. They are also entitled to receive dividends above the 3% cumulative dividend, to the extent declared by Company XYZ’s Board of Directors on Class A and Class B common shares, but only in periods when the issuing company has positive retained earnings. Evaluation: The preferred stockholders do not share in the losses of Company XYZ despite being entitled to the liquidation preference of $20 per share. Therefore, Company XYZ would not include the participating preferred shares in its computation of basic loss per share for the year 2001. Nonetheless, because the preferred shareholders are entitled to participate only during periods in which Company XYZ has positive retained earnings, Company XYZ would exclude the participating preferred shares in its computation of basic EPS in 2002 because it remains in a retained deficit position. Company XYZ would include the participating preferred stock in the computation of basic EPS for 2003 under the two-class method. In 2003, $75,000 of undistributed earnings would be allocated to Class A and Class B common stock as well as to the Series A preferred stock, because Company XYZ has positive retained earnings at the end of 2003.

Issue 6: How is a convertible participating security included in the computation of diluted EPS?

The EITF decided to discontinue its discussion on Issue 6, noting that convertible participating securities should be included in the computation of diluted EPS using the if-converted method, subject to the antidilution provisions of SFAS 128.

Issue 7: Should the guidance in Topic D-95 be amended to require that the two-class method be used for including participating convertible securities in the computation of basic EPS in all cases, therefore eliminating the option for a company to establish use of the if-converted method as its accounting policy?

The EITF 03-6 Consensus was that the guidance provided in topic D-95 should be amended to require that the two-class method be used for including participating convertible securities in the computation of basic EPS. The if-converted method can no longer be used. The ratification of EITF 03-6 by FASB has nullified topic D-95.

This consensus will require companies to compute EPS for common stock separately from EPS for participating convertible securities.

Companies can no longer include the EPS for participating convertible securities with common stock, as was allowed under the if-converted method. This separation of EPS calculations may require companies to report basic EPS in a manner that was unintended at the time the participating convertible securities were issued.

Example. The UniFirst Corporation (UNF) has a capital structure with two classes of residual equity: common stock and Class B common stock. The common stock issue contains one vote per share and receives a 25% additional dividend above the Class B common stock. The Class B common stock contains 10 votes per share and can be converted into the common stock issue at the option of the holder on a 1:1 basis.

The company reported the following operating activities for its 39-week reporting period ending on May 29, 2004:

Net income                               $26,058,000
Weighted shares outstanding:
Common stock (est.)                  9,013,000
Class B common stock (est.)     10,178,000
Total weighted shares
outstanding                                19,191,000

Basic EPS using the if-converted method:

Net income ÷ weighted shares $26,058,000 ÷ 19,191,000 = $1.36

Basic EPS per EITF 03-6 using the two-class method:

Weighted shares:
Common stock:                         9,013,000
Add 25% bonus adjustment       2,253,000
Total equivalent
common shares                        11,266,000
Class B common stock            10,178,000
Total weighted shares               21,444,000

Allocation of net income:

Common stock: (11,266,000 ÷ 21,444,000) ¥ $26,058,000 = $13,690,000
EPS: $13,690,000 ÷ 9,013,000 = $1.52
Class B common stock: (10,178,000 ÷ 21,444,000) ¥ $26,058,000 = $12,368,000
EPS: $12,368,000 ÷ 10,178,000 = $1.21

Conforming to the provisions of EITF 03-6 erodes the Class B common stock by $0.15 or 11%. In an e-mail communicated to the EITF, UNF’s senior vice president and CFO voiced his displeasure with these results:

It is the Company’s opinion that this will not result in a fair presentation of the income per share for either class of stock. In view of the fact that the Class B shareholders control approximately 90% of the vote and that the Class B shares can be converted at any time this [sic] presentation significantly overstates the income per share of the Common Stock. In summary, the Company believes adopting the current version of EITF 03-6 will not result in a fair presentation of the income per share for either class of stock and will be misleading to investors.

Issue 8: Should the guidance in Topic D-95 be expanded to address other forms of participating securities, or should it continue to address only convertible participating securities?

The EITF 03-6 Consensus was that the guidance in Topic D-95 should be expanded to include all participating securities, convertible and nonconvertible, and should therefore also include options, warrants, forwards, and other contracts to issue a company’s common stock.

Effective Date and Analysis

FASB ratified the consensuses reached by the EITF on this issue at its March 31, 2004, meeting. The consensuses are effective for fiscal periods beginning after March 31, 2004, and are applied by restating previously reported EPS. This retroactive application is consistent with the application of previous consensuses and other accounting standards that have affected the computation and presentation of EPS.

EITF 03-6 will require companies to reevaluate their outstanding securities to determine whether a security is considered participating. Additionally, the consensuses will require companies to reassess how they allocate undistributed earnings to a participating security. Allocation must be based on the contractual participation rights of the security and not on arbitrary assumptions. Additionally, allocation must continue to be made in a period of net loss even if the effect is antidilutive.

The consensuses will also require companies to reexamine their use of the two-class method of computing EPS. Companies with participating securities, convertible or nonconvertible, are now required to use the two-class method and can no longer use the if-converted method. Companies would be well advised to assess the impact of EITF Issue 03-6 on their financial statements and related footnote disclosures in a timely manner and inform their shareholders about potential changes.