Case 16-4 To Dilute or Not to Dilute?

Requirements:

You need to come up with prescriptive guidance for the client. In other words, explain to the client what they should consider and how they should to compute the two metrics (organic revenue growth and operating margin) as of 12/31/2014 to use in the diluted EPS evaluation. You can/should use the different scenarios to illustrate your instructions, but you should not provide multiple answers per question (i.e., one per scenario). It should be one cohesive response that references appropriate sections and quotes from the ASC and then uses the examples/scenarios to illustrate the accounting application.

Case Study:

Performance Apparel Inc. (PA) is a retailer of sports apparel and footwear. PAs operations are based in Beaverton, Oregon, with retail stores located throughout the country. In an effort to motivate certain members of senior management to execute consistently with PAs long-term financial performance plan, it decided to issue performance-based restricted stock units (RSUs) on January 1, 2014.

RSUs are a form of compensation offered by an employer in the form of company stock. These shares of company stock are restricted in that they vest only after certain conditions (restrictions) are met. The shares are earned or vested based on a vesting schedule consistent with the satisfaction of these conditions. Vesting schedules are specific to each award and can be based on various conditions such as service (remaining with the employer for a certain period of time), performance milestones (such as meeting sales goals), or a combination.

These RSUs cliff vest (shares vest at a point in time) on the basis of continued employment after three years, with the number of RSUs earned and issued at the end of the three-year vesting period, if any, dependent on two performance conditions:

1. Three-year average organic revenue growth.

2. Three-year average operating margin.

Since PA has not previously issued these types of awards, it does not have knowledge of the relevant accounting literature and guidance on how these contingently issuable shares should be accounted for in their diluted earnings per share (EPS) calculation. Accordingly, as PAs external auditor, management has asked for your assistance with its financial statements as of and for the year ended December 31, 2014.

Required: As of December 31, 2014:

1. What is the three-year average organic growth rate that PA should assume in determining the number of potentially outstanding dilutive awards for purposes of calculating diluted EPS?

2. What is the three-year average operating margin that PA should assume in determining the number of potentially outstanding dilutive awards for purposes of calculating diluted EPS?

Scenarios:

For the year ended December 31, 2014, organic revenue increased 10 percent.

For the year ended December 31, 2014, the operating margin was 40 percent.

For the year ended December 31, 2014, organic revenue increased 20 percent on average the previous three years.

For the year ended December 31, 2014, the operating margin was 50 percent on average the previous three years.

Possible related ASC sections:

45-48 Shares whose issuance is contingent upon the satisfaction of certain conditions shall be considered outstanding and included in the computation of diluted EPS as follows:

a. If all necessary conditions have been satisfied by the end of the period (the events have occurred), those shares shall be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).

b. If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive. Those contingently issuable shares shall be included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).

45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the computation of diluted EPS.

45-50 Paragraphs 260-10-45-51 through 45-54 provide general guidelines that shall be applied in determining the EPS impact of different types of contingencies that may be included in contingent stock agreements.

45-51 If attainment or maintenance of a specified amount of earnings is the condition and if that amount has been attained, the additional shares shall be considered to be outstanding for the purpose of computing diluted EPS if the effect is dilutive. The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive. Because the amount of earnings may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied. Example 3 (see paragraph 260-10-55-53) illustrates that provision.

45-52 The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied.

45-53 In some cases, the number of shares contingently issuable may depend on both future earnings and future prices of the shares. In that case, the determination of the number of shares included in diluted EPS shall be based on both conditions, that is, earnings to date and current market priceas they exist at the end of each reporting period. If both conditions are not met at the end of the reporting period, no contingently issuable shares shall be included in diluted EPS.

45-54 If the contingency is based on a condition other than earnings or market price (for example, opening a certain number of retail stores), the contingent shares shall be included in the computation of diluted EPS based on the assumption that the current status of the condition will remain unchanged until the end of the contingency period. Example 3 (see paragraph 260-10-55-53) illustrates that provision.