Contingent issuance agreements
Definition and Explanation
Under various circumstances, a firm may enter into a contingent issuance agreement that calls for the issuance of shares if stated future events occur. Common examples are compensatory stock plans that do not require a cash contribution and agreements for the purchase of an existing company through the issuance of shares. The treatment of these contingency agreements for EPS depends upon the nature of the future events and the perceived likelihood of their occurrence. If it appears from present conditions that the future event will occur, the shares are included in the denominator for both primary and fully diluted EPS. If the future event is a higher level of earnings than is presently being attained, the shares are included only in the fully diluted denominator but the numerator is adjusted upward to the level necessary to achieve the issuance of the shares. This situation demonstrates clearly how the EPS number is typically a pro forma result rather than a description of actual performance. A contingent issuance agreement is considered antidilutive if the addition to earnings divided by the number of issuable shares exceeds EPS without considering the agreement.
Suppose that Sample Company’s reported earnings for 20×1 are $7,000,000 and that the weighted average of outstanding shares is 1,400,000. There exists a contingent issuance agreement such that 400,000 shares will be issued if earnings reach $7,200,000. Because the earnings requirement has not yet been met, the contingent shares are included only in fully diluted EPS. In that calculation, $200,000 of hypothetical earnings must be added to the actual earnings in the numerator. The computations are shown below: