Options in EPS Calculations in IAS 33

Options in EPS Calculations, warrants and their equivalents

This narrative builds on the basic principles introduced in EPS or earnings per share, and sets out the specific basic and diluted EPS implications of the following types of instrument(s).

For EPS purposes, ‘options, warrants and their equivalents’ (collectively, ‘options’ in this chapter) are financial instruments that give holders the right to purchase ordinary shares. Options in this chapter are generally written calls that give holders the right, but not the obligation, to acquire an entity’s ordinary shares with cash and/or by providing goods or services. If an entity receives goods or services in exchange for the options, then the transaction generally falls in the scope of IFRS 2 Share-based Payment; other options are generally in the scope of IAS 32 Financial Instruments: Presentation. [IFRS 2.2, IAS 33.5]

In addition, the options discussed in this chapter are those that may require settlement in ordinary shares. An option that is always settled net in cash does not entitle its holder to ordinary shares; this option is therefore not a POS and is ignored in diluted EPS. [IAS 33.5]

This chapter covers the EPS implications for options in general. Some instruments may require additional consideration, which are set out in the following chapters:

• written put options and forwards: Written puts and forwards, as discussed here, are those that may require an entity to purchase its ordinary shares. Typically, these instruments are in the scope of IAS 32 Financial Instruments: Presentation. Generally, shares that are subject to written puts or forwards are not regarded as outstanding in basic EPS but do impact diluted EPS. Understanding the accounting for these instruments is also relevant, because it determines whether their assumed conversion would have a consequential effect on profit or loss. Generally, written puts or forwards are dilutive if they are in-the-money – i.e. the exercise or settlement price is higher than the average market price of the ordinary shares. [IAS 33.63] However, if these instruments are accounted for as liabilities under IAS 32, then the numerator adjustment could vary and could therefore affect whether the instruments are dilutive.
• purchased puts and calls held by an entity over its own ordinary shares. Purchased puts and calls are ignored in both basic and diluted EPS.
• options embedded in other financial instruments: see Convertible instruments;
• options subject to performance conditions other than service conditions: see Contingently issuable ordinary shares; and
• options to purchase convertible instruments: Options or warrants to purchase convertible instruments – e.g. an option to purchase convertible preference shares – may also be considered POSs. In many cases, these options do not meet the requirements for classification as equity instruments under IAS 32 and are accounted for as derivatives under IFRS 9 Financial instruments. In such cases, the options are assumed to be exercised to purchase the convertible instrument in diluted EPS only when:
  • the average price of the convertible instrument is above the exercise price of the option;
  • the average price of the ordinary shares obtainable on conversion is above the exercise price of the option; and
  • the conversion of similar outstanding convertible instruments, if there are any, is also assumed. [IAS 33.A6]However, IAS 33 is not clear on how to calculate the impact of these instruments in diluted EPS. Because they are options, in general one acceptable approach is to use the treasury share method in determining the impact on the denominator, assuming that the options would be exercised directly to obtain shares on conversion (see 5.9.40). The post-tax consequential changes in income or expense would be adjusted in the numerator.

Additional considerations in the context of share-based payment arrangements are set out in EPS Impact of share-based payments.

EPS implications

Generally, options impact only diluted EPS. If the options are vested and require little or no further consideration to be exercised, then in our view they should be included in basic EPS. Understanding the accounting for these options is also relevant, because it determines whether their assumed conversion would have a consequential effect on profit or loss.

Potential impact on basic EPS	Potential impact on diluted EPS
The numerator is not affected, the denominator might or might not be affected.	The numerator might or might not be affected, the denominator is affected.
Options are generally ignored in basic EPS because they are not ordinary shares. However, if options are exercisable for little or no further consideration after vesting, then in our view they should be included in the denominator from the vesting date.	To the extent that they are not yet taken into account in basic EPS, options are POSs. The potential adjustment to the numerator depends on the accounting for the options under IFRS 2 or IAS 32, which is driven by their manner of settlement, as follows. For an example of options that require numerator adjustments, see the case – Share-based payment – Counterparty has the settlement choice. The potential adjustment to the denominator is determined using the treasury share method. The potential adjustment is included from the beginning of the period, or from the date on which the options are issued or granted if this is later.

Dilutive or anti-dilutive?

Generally, options are dilutive if they are in-the-money – i.e. the exercise price (including the fair value of any goods or services to be supplied to the entity in the future) is lower than the average market price of the ordinary shares. However, for options that are accounted for as liabilities under IFRS 2 or IAS 32, the numerator adjustment could vary (see above) and could therefore affect whether the options are regarded as dilutive. [IAS 33.47]

Denominator adjustment for options – The treasury share method

Generally, the denominator for diluted EPS (IAS 33 Earnings per share) assumes that all dilutive POSs have been converted into ordinary shares at the beginning of the period or, if later, the date of issue of the POSs; in addition, they are included in the denominator only for the period during which they are outstanding (see 4.3.20). In the context of options, rather than simply adding to the denominator the weighted-average number of ordinary shares that would be issued from the assumed conversion of options, IAS 33 prescribes a specific method, commonly referred to as the ‘treasury share method’. [IAS 33.45–46]

The treasury share method is different from that prescribed for options that are ‘embedded’ in other financial instruments – e.g. convertible debt (see Chapter 5.11). This is irrespective of the fact that IAS 32 and IAS 39 usually require split accounting for options embedded in another host instrument and therefore stand-alone and embedded options are generally treated in the same way under those standards.

The treasury share method assumes that the proceeds (exercise price) from exercising the option are used to repurchase shares at the average market price of a share during the period. The bonus element is the difference between the number of ordinary shares that would be issued at the exercise price and the number of ordinary shares that would have been repurchased at the average market price. Only the bonus element of the options – i.e. the number calculated under Step (iii) below – is reflected in diluted EPS. The following diagram summarises the treasury share method. [IAS 33.45–46]

Some of the key inputs in the above formulas are further explained below.

Assumed proceeds

The ‘exercise price’ includes the fair value (measured in accordance with IFRS 2) of any goods or services to be supplied to the entity in the future under the share-based payment arrangement (see Chapter 5.17). [IAS 33.47A]

Average market price of ordinary shares

The average market price is determined based on the full reporting period or, in our view, the period for which the options are outstanding if this is shorter (see below). For example, if the options are outstanding only for six months of the reporting period, then in determining the bonus element the average market price should be based on the average market price during that six-month period.

When determining the average market price for a period, in theory every market transaction could be included. However, as a practical matter the application guidance of IAS 33 notes that a simple average of weekly or monthly prices is usually adequate.

The guidance adds that although closing market prices are generally adequate for calculating the average market price, when prices fluctuate widely an average of the high and low prices usually produces a more representative price. The method used to calculate the average market price is used consistently unless it is no longer representative because of changed conditions.

For example, an entity that uses closing market prices to calculate the average market price for several years of relatively stable prices might change to an average of high and low prices if prices start fluctuating greatly and the closing market prices no longer produce a representative average price. [IAS 33.A4–A5]

In some cases, there may not be a quoted market price for the ordinary shares for the full period. This may be the case if, for example, the entity does not have ordinary shares or POSs that are publicly traded and the entity elects to disclose EPS, or if the entity’s ordinary shares or POSs were not listed for the full period.

For example, an entity with an annual reporting period ending on 31 December Year 1 lists its ordinary shares on 7 November Year 1, so that it has a quoted market price for its shares only during the period from 7 November to 31 December Year 1.

In general, if the average market price of the shares is necessary to calculate diluted EPS – e.g. because the entity has outstanding warrants or options – then the average market price used should be a meaningful average for the full reporting period, or the period for which the POSs are outstanding if this is shorter. We do not believe that an average market price for approximately two months, as in the example, would be meaningful for POSs outstanding for the full year.

In general, if there is no active market for ordinary shares, then an entity should determine fair value using valuation techniques. We believe that an entity should apply the guidance for measuring the fair value of financial instruments to determine the fair value of unquoted equity instruments to estimate the average market price for the ordinary shares. Specialist expertise may be required in this assessment. The method used to determine the average market price should be disclosed in the notes to the financial statements. [IFRS 13]

Exercise price settled (or partially settled) by other instruments

Some options may permit or require an entity to tender a debt or another instrument issued by the entity itself or its subsidiary in payment of all or a portion of the exercise price of the option.

These options may be dilutive if (a) the average market price of the ordinary shares for the period exceeds the exercise price or (b) the selling price of the instrument to be tendered is below that at which the instrument may be tendered under the option and the resulting discount establishes an effective exercise price that is below the market price of the ordinary shares obtainable on exercise.

In such cases, the exercise of the options and the tendering of the instruments are assumed for diluted EPS. Post-tax interest on any debt assumed to be tendered is added to the numerator. IAS 33 is not clear on how to calculate the impact of such options on the denominator for diluted EPS. In our view, one acceptable approach is to use a similar approach to that for convertible instruments (see Chapter 5.11) – i.e. not the treasury share method.

This means that, for the portion for which the exercise price may be paid up by tendering debt or other instruments, the denominator should be adjusted for the total number of shares assumed to be issued. [IAS 33.A7]

However, if the option may be settled in cash, then the cash alternative should be assumed if it is more advantageous to the option holder. In such cases, the treasury share method should be used to determine the impact on the denominator for the diluted EPS. [IAS 33.A7]

Similar treatment is given to preference shares or other instruments that have conversion options that permit the investor to pay cash for a more favorable conversion rate. [IAS 33.A8]

Proceeds used to redeem other instruments

In some cases, the terms of options require the proceeds received from exercise to be used to redeem debt or other instruments of the entity (or its parent or a subsidiary). In determining diluted EPS, it is assumed that the proceeds are used first to purchase these other instruments at their average market price, and the numerator is adjusted by the post-tax interest saving on the assumed redemption. If the proceeds to be received exceed the redemption amount, then the excess is assumed to be used to purchase ordinary shares under the treasury share method. [IAS 33.A9]

Case – Options settled gross in shares

The following basic facts relate to Company P. Net profit for Year 1 is 4,600,000. The number of ordinary shares outstanding on 1 January Year 1 is 3,000,000. The following facts are also relevant for Year 1. P has the following share options issued to third parties (non-employees) under equity-settled share-based payments during the year. Terms Option A Option B Option B Total number of options 200,000 1,500,000 500,000 Issuance (and vesting) date Before 1 January Before 1 January 01/07/21 Options exercised – 500,000 on 30 June – Exercise price per option – (no consideration) 10 20 Each option is convertible into one ordinary share. The options do not entitle the holders to dividends before they are exercised. The average market prices of P’s ordinary shares are as follows. Year ended 31 December: 15 Six months ended 31 December: 16 Workings The EPS computations for Year 1 are as follows. Basic EPS Diluted EPS 1. Determine the numerator No adjustment is necessary. The numerator is 4,600,000. 1. Identify POSs Although the options under Option A have not been converted into ordinary shares during the year, they have been included in basic EPS throughout the period because they can be exercised for no further consideration and they were vested for the full period. Accordingly, they are not POSs throughout the year. Unlike the options under Option A, those under Options B and C are exercisable for more than little consideration and are therefore POSs for the period during which they are outstanding. 2. Determine the denominator Because the options under Option A are vested and exercisable for little or no further consideration, they are included in the denominator from the vesting date – i.e. included throughout the year. The options under Options B and C are ignored in basic EPS until they are actually exercised, because the exercise price is more than little consideration. P calculates the denominator as follows. The denominator is therefore 3,450,000. 2. For each POS, calculate EPIS Potential adjustment to the numerator for EPIS: No adjustment is required because the options under Options B and C are equity-settled (see 5.17.70). Potential adjustment to the denominator for EPIS: The adjustment is determined using the treasury share method, as follows. Notes 1. In this step, the weighted-average number of options under Option B reflects the exercise of 500,000 options on 30 June – i.e. ((1,000,000 x 12) + (500,000 x 6)) / 12 = 1,250,000. The weighted-average number of options under Option C reflects the fact that the options were issued on 1 July – i.e. 500,000 x 6/12 = 250,000. 2. The options under Option C are anti-dilutive and therefore are ignored in the denominator, because the exercise price is higher than the average market price for the period during which these options are outstanding. 3. Determine basic EPS Basic EPS = 4,600,000 / 3,450,000 = 1.33 3. Rank the POSs This step does not apply. Because the options under Option C are anti-dilutive, the options under Option B are the only class of POS considered. 4. Determine basic EPS from continuing operations Basic EPS is 1.33 (see Step 3 of basic EPS computation). 5. Identify dilutive POSs and determine diluted EPS The options under Option B are dilutive because no adjustment to the numerator for EPIS is required and the exercise price is lower than the average market price of an ordinary share during the period. Accordingly, P includes the impact of the Option B options in diluted EPS. Diluted EPS = 1.19

Case – Options – Proceeds used to redeem debt or other instruments of the entity

The following basic facts relate to Company P. Net profit for Year 1 is 4,600,000. The number of ordinary shares outstanding on 1 January Year 1 is 3,000,000. The following facts are also relevant for Year 1. On 1 January, P issues 200,000 equity-settled share options. Each option may be exercised to purchase one ordinary share. The exercise price of each option is 100. The holders of the options also own 50,000 notes issued by P. The terms of the options require P to use the exercise proceeds to repurchase these notes. The average market price of P’s ordinary shares during the year is 95. The average selling price of each note during the year is 90. The interest expense for the year relating to the notes to be repurchased is 50,000. The interest expense is tax-deductible. The applicable income tax rate is 40%. Workings The EPS computations for Year 1 are as follows. Basic EPS Diluted EPS 1. Determine the numerator No adjustment is necessary. The numerator is 4,600,000. 1. Identify POSs Options are exercisable for more than little consideration and are therefore POSs for the period during which they are outstanding. 2. Determine the denominator No adjustment is necessary until the options are exercised and ordinary shares are issued, because they are exercisable for more than little consideration. There is no change in the number of outstanding shares during the year. The denominator is therefore 3,000,000. 2. For each POS, calculate EPIS As mentioned in 5.9.80, it is assumed that the proceeds from the exercise price would be used to repurchase the notes. Therefore, 4,500,000 (50,000 x 90) of the total proceeds of 20,000,000 (200,000 x 100) is not considered as assumed proceeds in applying the treasury share method. Potential adjustment to the numerator for EPIS: The redemption of the notes would increase profit or loss for the year by the post-tax amount of the interest expense: (interest expense on the notes) x (1 – income tax rate) = (50,000) x (1 – 40%) = 30,000 Potential adjustment to the denominator for EPIS: The adjustment is determined using the treasury share method, as follows. Only the proceeds exceeding the assumed repurchase of the note are used. EPIS is calculated as follows. EPIS = 30,000 / 36,842 = 0.81 3. Determine basic EPS Basic EPS = 4,600,000 / 3,000,000 = 1.53 3. Rank the POSs This step does not apply, because the options are the only class of POSs considered. 4. Determine basic EPS from continuing operations Basic EPS is 1.53 (see Step 3 of basic EPS computation). 5. Identify dilutive POSs and determine diluted EPS The potential impact of the options is determined as follows. Accordingly, P includes the impact of options in diluted EPS. Determine Diluted EPS = 1.52

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