# What Does The Treasury Stock Method Assume About The Exercise Date? What Is The Exception To The Rule With Respect To The Assumed Exercise Date? What Alternative Procedure Is Employed In This Instance?

To begin, we are given two assumptions that the current share price (i.e., equity value per share) is \$20.00 and the basic shares outstanding is 10mm. If we were to ignore the dilutive impact of non-basic shares in the calculation of equity value, we would arrive at \$200mm (\$20.00 per share x 10mm basic shares outstanding). Upon dividing the exercise proceeds of \$250,000 by the current market share price of \$50.00, we get 5,000 as the number of shares repurchased. And then, we subtract the 5,000 shares repurchased from the 10,000 new securities created to arrive at 5,000 shares as the net dilution (i.e., number of new shares post-repurchase). In the subsequent step, the TSM assumes the entirety of the proceeds from the exercising of those dilutive options goes towards repurchasing stock at the current market share price.

The treasury stock method approximates what a company’s earnings per share would be under the assumption that its dilutive securities, such as options, are exercised. Earnings per share is a financial measure that indicates whether a company is profitable. Explore its definition and learn how to use the formula to calculate earnings per share in order to understand the importance of net income, preferred dividends, and common shares. When employees are given stock options or restricted stock, they often do not gain control over the stock or options for a period of time. This period is known as the vesting period and is usually 3 to 5 years.

## Effect On Diluted Eps

As we’ll see shortly, both Options and Restricted Stock can add new shares to the Share Count. Stock Options offer the employees the ‘Option’ to buy Shares of Stock at a specific price, called the ‘Strike Price’ (or ‘Exercise Price’).

Third, we need to calculate the Net New Shares by deducting the Repurchased Shares from the new Shares created by the employee Option Exercises. The Repurchased Shares offset the new shares created by the Option Exercise. When employees exercise their Options, they pay the Strike Price and receive shares in return and the Company receives the Option Proceeds payment.

## Treasury Stock Method Example

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• The number of common shares outstanding is adjusted retroactively for stock dividends, stock splits and reverse stock splits.
• The if-converted method also applies to convertible preferred stock.
• Gordon Scott has been an active investor and technical analyst of securities, futures, forex, and penny stocks for 20+ years.
• In Finance, we use the Treasury Stock Method to add the new shares created when an employee exercises their Options.
• Generally Accepted Accounting Principles mandates that companies must provide details on their diluted EPS.
• The company then calculates EPS for continuing operations, taking into account the potential shares with the lowest incremental EPS first.

Diluted EPS is a performance metric used to assess a company’s earnings per share if all convertible securities were realized. Both investors and businesses have a required rate of return for potential investments and projects. Below is an extract of the Options Table of Infosys from the 2008 Annual Report. Use the Current Market Price of Infosys (Rs2,450/- per share)and use the table below to calculate the effect of stock options on the Equity Base.

## Illustration Of Treasury Stock Method

Fully diluted shares outstanding (“FDSO”) is computed as basic common shares outstanding plus any share equivalents resulting from the hypothetical exercise of in-the-money (“ITM”) options and conversion of convertible securities. In terms of the steps involved in the TSM, first, the number of in-the-money options and other dilutive securities are summed up and that figure is then added to the number of basic shares outstanding. Note that only the securities deemed “in-the-money” are assumed to have been exercised, therefore those “out-of-the-money” are not included in the new share count.

In Finance, we use the Treasury Stock Method to add the new shares created when an employee exercises their Options. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Generally Accepted Accounting Principles mandates that companies must provide details on their diluted EPS.

## Understanding Warrants And Call Options

The if-converted method also applies to convertible preferred stock. The stock is assumed converted at the beginning of the period if it is outstanding at that time. Stock issued during the period is treated as if it were converted at the date of issuance. The earnings per incremental share equals the preferred stock dividends divided by the number of shares of common stock issued from the assumed conversion.

• The proceeds garnered by the presumed option or warrant exercise is assumed to be used to purchase common stock at the average market price during the reporting period.
• The If-Converted Method looks at the conversion impact of the Convertible versus the impact to Earnings Per Share for the Business post-conversion.
• OPTIONS, WARRANTS AND THEIR equivalents are included in EPS using the treasury stock method, which is different from the method used in Opinion no. 15.
• They include all Restricted Stock to ensure they capture the full potential impact to the Share Count for the same reasons discussed above with Options.
• Earnings per share is a financial measure that indicates whether a company is profitable.

A company should report per share amounts for discontinued operations, extraordinary items and the cumulative effect of an accounting change in a period either on the face of the income statement or in the notes to the financial statements. It should present basic EPS for all periods for which income statements or summaries of earnings are presented. The number of common shares outstanding is adjusted retroactively for stock dividends, stock splits and reverse stock splits. For example, if a stock splits in June 1997, the weighted average number of shares is computed assuming the split occurred at the beginning of 1997. A companys presentation of EPS in its financial statements for any earlier years also has to be adjusted for the split. If the split occurs in early 1998, before the 1997 statements are issued, those statements and all other years presented have to be adjusted as well.

## Convertible Debt And Equity Basics

Contingent shares whose issuance depends solely on the passage of time are considered already issued in calculating diluted EPS. A company calculates an earnings per incremental share for each block of shares. A company makes the same computation for each block of shares whose issuance is contingent on factors other than time when the contingency is currently satisfied. The “watering down” or decrease in EPS from the exercise or conversion of securities into common stock. A security under APB Opinion no. 15 that is in substance equivalent to common stock because of the terms or circumstances at the time of issuance. These securities were deemed to be those whose exercise or conversion was probable. A decrease in the loss per share or increase in earnings per share caused by inclusion of a contingent security, convertible security, option or warrant in diluted EPS.

Therefore, the GAAP method is utilized to compute this figure for financial reporting. The rules from Opinion no. 10 concerning the liquidation preference of preferred stock. FASB Statement no. 128 allows presentation of more relevant information for financial statement users. The increased share count lowers the value available for each shareholder. When an employee exercises Options, the Option exercise adds new shares to the Basic Share Count. In return, the employer receives money, but there’s a disconnect because we cannot add dollars to the Share Count.

## Why Options Exercisable Is Used For Treasury Stock Method

The process stops when the resulting diluted EPS is the lowest figure obtainable. The company then calculates EPS for continuing operations, taking into account the potential shares with the lowest incremental EPS first. If the new figure is lower than the previous one, the company recalculates EPS, including the potential shares with the next lowest incremental EPS. The process of including increasingly less dilutive shares continues until the resulting EPS figure increases or there are no more potential shares. Introducing blocks of potential common shares in the order of decreasing effect on diluted EPS guarantees that the final figure expresses maximum dilution. Basic net loss per share excludes the effect of dilution and is computed by dividing net loss by the weighted-average number of shares outstanding for the period. Diluted net loss per share reflects the potential dilution that could occur if securities or other contracts to issue shares were exercised into shares.

In that situation, the potential shares are antidilutive and not included in the companys EPS calculation. Statement no. 128 says that if there is a loss from continuing operations, diluted EPS is the same as basic EPS. This is a required calculation for a publicly-held company, since all public entities must report their diluted earnings per share on the face of the income statement.

## Diluted Shares Calculation Example: Foot Locker

When exercising warrants and options, the exercise date assumed is the start of the reporting period. The treasury stock method implies that the money obtained by the company from the exercising of an in-the-money option is used for stock repurchases. Repurchasing those shares turns them into treasury stock, hence the name. The effect of preferred dividends in arriving at income available to common stockholders in basic EPS.

### How do you retire treasury shares?

Under cost method, the journal entry for the retirement of treasury stock is made by debiting the common stock with par value of shares being retired, debiting additional paid-in capital (if any) associated with the shares being retired and crediting treasury stock with the cost of shares being retired.

Recall how the TSM assumes the company repurchases shares at the current share price, thus the strike price is multiplied by the number of potential new shares, before being divided by the current share price. Furthermore, the EPS formula divides the net income of a company by its share count, which can be either on a basic or diluted basis. That said, if a company has issued such securities in the past (i.e., the potential for conversion), its diluted EPS in all likelihood is going to be lower than its basic EPS. FASB Statement no. 128 and IASC Standard 33 bring U.S. and international GAAP into concurrence on calculating the number of shares in the EPS denominator. Although the numerator in EPS calculations in both statements is income available to common shareholders, the two standard-setting bodies avoided addressing differences between U.S. and international GAAP in computing net income. While these statements bring some comparability to EPS in companies from different countries, users must be aware that the net income computation is not necessarily comparable and hence EPS amounts of such companies are not completely comparable.

## Fully Diluted Shares Outstanding Step 17

It then uses the proceeds to repurchase fewer shares at the higher exercise price. The incremental number of shares remaining increases the denominator of diluted EPS. The second new method replaces the treasury stock method when calculating the effect of a stock rights issue. The bonus element in a rights issue has the same effect as a stock dividend, requiring a restatement of shares outstanding. The restatement factor is applied to the denominator of both basic and diluted EPS. A company with income from continuing operations must calculate diluted EPS.