Treasury Stock Method

Treasury Stock Method
See also
Fully Diluted Shares Full Ratchet Free cash flow yield Earnings Multiplier Appreciated asset Implicit interest rate Distribution In Kind Book value per share Yield maintenance

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.

“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.”

Assumptions of the treasury stock method

The treasury stock method assumes that:

• 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.

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.”

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