Treasury Stock Method vs. If-Converted: Which to Use?

Earnings Per Share (EPS) is a fundamental financial metric, offering investors insight into a company’s profitability on a per-share basis. Companies disclose various forms of this measure, with diluted EPS providing a comprehensive view of potential earnings. This calculation accounts for future shares that could come into existence. Calculating diluted EPS involves complexities because certain financial instruments have the potential to convert into common stock. If exercised or converted, these instruments would increase the total number of outstanding shares, thereby reducing the earnings attributable to each existing share.

Understanding Diluted Earnings Per Share

Basic EPS indicates how much of a company’s net income is allocated to each outstanding share of common stock. It is calculated by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during a period. Public companies are generally required to present both basic and diluted EPS.

Diluted EPS extends this concept by considering the potential impact of all financial instruments that could increase the number of common shares outstanding. This process, known as dilution, provides a more conservative and realistic view of a company’s per-share profitability. The inclusion of these potential common shares in the diluted EPS calculation ensures that investors and analysts consider the “worst-case” scenario for shareholder earnings. It highlights the full extent of a company’s outstanding equity if all eligible securities were to be converted or exercised.

Potentially dilutive securities include:
Stock options: These give holders the right to purchase shares at a set price.
Warrants: Similar to options, but typically issued by the company itself.
Convertible bonds: Bondholders can exchange their debt for common stock.
Convertible preferred stock: Allows preferred shareholders to convert their shares into common stock.

The Treasury Stock Method

The Treasury Stock Method (TSM) is an accounting technique used to determine the dilutive effect of stock options, warrants, and their equivalents on diluted Earnings Per Share. This method is applied when these “in-the-money” securities are assumed to be exercised. An option or warrant is considered “in-the-money” if its exercise price is below the average market price of the common stock during the reporting period.

The underlying principle of TSM assumes that any cash proceeds a company receives from the hypothetical exercise of these options or warrants would be used to repurchase its own common stock from the open market. This repurchase is assumed to occur at the average market price of the stock during the period. The net effect of this hypothetical transaction determines the incremental shares added to the denominator of the diluted EPS calculation. This method primarily applies to stock options granted to employees and warrants issued by the company. It reflects the potential increase in outstanding shares that would result if holders chose to acquire common stock.

To illustrate the calculation, consider a company with 10,000 outstanding stock options, each with an exercise price of $20. If the average market price of the company’s stock during the reporting period is $25, these options are in-the-money. The total cash proceeds from exercising all options would be $200,000 (10,000 options multiplied by the $20 exercise price).

TSM assumes these $200,000 in proceeds are used to repurchase shares at the average market price of $25 per share. The company could hypothetically repurchase 8,000 shares ($200,000 divided by $25 per share). The net increase in shares is determined by subtracting the shares repurchased from the shares issued upon exercise. In this example, 10,000 shares would be issued, and 8,000 shares would be repurchased, resulting in a net increase of 2,000 shares (10,000 – 8,000). These 2,000 additional shares are then added to the basic weighted-average common shares outstanding to arrive at the diluted share count.

The If-Converted Method

The If-Converted Method is an accounting approach used to calculate the dilutive impact of convertible securities on diluted Earnings Per Share. This method is specifically applied to convertible bonds and convertible preferred stock. It assumes that these securities were converted into common stock at the beginning of the reporting period, or at their date of issuance if that occurred later in the period.

The underlying principle of this method is to reflect the potential increase in common shares and the corresponding reduction in interest expense or preferred dividends that would occur upon conversion. This hypothetical conversion impacts both the numerator (net income) and the denominator (shares outstanding) of the EPS calculation. The goal is to present a diluted EPS that considers this potential capital structure change. This method primarily applies to convertible bonds, which are debt instruments exchangeable for common shares, and convertible preferred stock, which are equity shares convertible into common shares. The conversion terms, such as the conversion ratio, are specified in the security agreement.

To illustrate the calculation, consider a company with $1,000,000 in convertible bonds outstanding, with each $1,000 bond convertible into 50 common shares. The bonds carry an annual interest rate of 6%, and the company’s tax rate is 21%.

If these bonds were converted, common shares outstanding would increase by 50,000 shares ($1,000,000 bond value divided by $1,000 per bond, multiplied by 50 shares per bond). The annual interest expense is $60,000 ($1,000,000 multiplied by 6%). This interest expense, previously deducted from net income, would no longer be incurred. The after-tax interest expense to be added back to net income is $47,400 ($60,000 multiplied by (1 – 0.21)). This adjusted net income, along with the increased share count, is then used to compute diluted EPS.

Comparing the Methods and Their Application

The Treasury Stock Method and the If-Converted Method serve distinct purposes in calculating diluted Earnings Per Share, each addressing different types of potentially dilutive securities. TSM applies to stock options and warrants, focusing on the assumed use of proceeds from their exercise to repurchase shares, affecting only the denominator. In contrast, the If-Converted Method is used for convertible bonds and convertible preferred stock, assuming their conversion into common stock, impacting both the numerator and the denominator.

The choice of method depends entirely on the nature of the dilutive instrument a company possesses. Companies must apply the appropriate method based on the specific characteristics of their dilutive instruments to comply with accounting standards. These methods are not interchangeable, as they reflect different economic assumptions about how potential shares would come into existence. Both methods contribute to providing a more accurate and conservative diluted EPS figure.