Treasury Stock Method
Treasury inventory method - this is the method used by companies to calculate the number of new shares that can potentially be created by unexercised in-the-money warrants and options. Used to identify the use of continuations that can be obtained after developing options and warrants when calculating diluted EPS. It agrees that any continuation will be used to buy ordinary shares at average market value during this period^{[1]}^{[2]}.
"Net income available to common stockholders (the numerator) frequently differs because of the differences in the methods of determining compensation cost under each of these standards. Furthermore, the weighted-average number of common shares outstanding (the denominator) in computations of diluted earnings per share may differ due to the differences in the determination of assumed proceeds in application of the Treasury stock method^{[3]}."
Assumptions of the treasury stock method
The treasury stock method assumes that^{[4]}:
- options and warrants are worked out at the starting of the year (or on the date of issuance in case issued amid the year)
- the proceeds from work out are utilized to repurchase shares (at the normal stock cost for the year) for the treasury.
The resulting effect of the second assumption is to moderate the increase in the number of shares still outstanding. The excess of the shares accepted to be issued in step 1 less the shares repurchased in step 2 is the number of incremental shares included to the EPS denominator. An incremental sum will exist when the work out cost is less than the stock's market cost since the reserves will not be sufficient to purchase back all of the shares. The warrants do not affect the ESP numerator, because they do not pay interest or dividends. When the options are anti-dilutive and are ignored for the purpose of calculating diluted ESP, this means that the exercise price of the warrant or option is higher than the market price of the shares. In this situation, enforcement is not expected and dilution need not be considered^{[5]}.
Example of treasury stock method
"For example, assume that a company has 2,000 warrants outstanding, each of which can be exercised for the purchase of one share of common stock at $15 per share, and the average market price of the common stock during the year is $45. The treasury stock method first assumes that all the warrants are exercised, which leads to the issuance of 2,000 shares of common stock, accompanied by a cash inflow of $30,000 (2,000 x $15). Next, the company is assumed to use the cash received to repurchase shares for the treasury. At the average market price, 667 shares can be repurchased ($30.000/$45). The net result is that 1,333 (2.000-667) incremental shares would be outstanding and are added to the EPS denominator in computing diluted EPS^{[6]}."
Advantages of Treasury Stock Method
The Treasury Stock Method is a useful tool for calculating the number of new shares that can potentially be created by unexercised in-the-money warrants and options. The advantages of this method include:
- Accurately accounting for the exercise of options and warrants in the calculation of diluted EPS, allowing companies to make more informed decisions about their capital structure
- Allowing companies to track their stock dilution over time
- Providing an easy-to-understand means of understanding the potential impact of dilution on EPS
- Offering an alternative to the more complex and time-consuming traditional methods of calculating diluted EPS.
Limitations of Treasury Stock Method
The Treasury Stock Method is a useful tool for companies to calculate the number of new shares that can potentially be created by unexercised in-the-money warrants and options. However, the Treasury Stock Method comes with certain limitations that should be considered. These limitations include:
- Difficulty in accurately estimating the value of unexercised options and warrants. The fair value of unexercised options and warrants is difficult to estimate as it depends on various factors, such as the stock price volatility and the company’s future prospects.
- The Treasury Stock Method does not take into account the impact of anti-dilutive securities. Anti-dilutive securities, such as certain preferred shares and convertible debentures, can lead to the dilution of earnings per share by reducing the number of outstanding shares.
- The method does not consider the effect of dilutive employee stock options. Employee stock options are not included in the calculation of diluted EPS if they are not expected to be exercised.
- The Treasury Stock Method does not take into account the impact of restricted stock awards. Restricted stock awards that may result in additional outstanding shares are not considered in the calculation of diluted EPS.
Treasury stock method is a method used by companies to calculate the number of new shares that can potentially be created by unexercised in-the-money warrants and options. Other approaches related to this method include:
- Weighted Average Dilution Method - this approach uses the average market value of the stock during the period to calculate the dilution.
- Expected Value Method - this method assumes that the stock price will remain constant over the period of the warrant or option.
- Simple Treasury Stock Method - this method takes into account the current market value of the stock when calculating the dilution.
In summary, the treasury stock method is a calculation used to identify the use of continuations that can be obtained after developing options and warrants when calculating diluted EPS. Other approaches related to this method use various assumptions about the stock price to calculate dilution.
Footnotes
Treasury Stock Method — recommended articles |
Fully Diluted Shares — Full Ratchet — Effective annual interest rate — Blended Rate — Exclusion ratio — Original issue discount — Future value — Property Dividend — Incremental borrowing rate |
References
- Carmichael D. R., Rosenfield P. H. (2003), Accountants' Handbook, Special Industries and Special Topics, John Wiley & Sons, Inc., Hoboken, New Jersey
- Flood J. M. (2014), Wiley GAAP 2015: Interpretation and Application of Generally Accepted Accounting Principles, John Wiley & Sons Ltd
- IMA (2014), Wiley CMAexcel Learning System Exam Review 2015: Part 1, Financial Planning, Performance and Control, John Wiley & Sons, Inc., Hoboken, New Jersey
- Siegel J. G., Dauber N. A., Shim J. K. (2011), The Vest Pocket CPA, John Wiley & Sons, Inc.
Author: Monika Wójcik