Treasury share method

Denominator adjustment for options

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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]

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