Treasury stock method
/What is the Treasury Stock Method?
The treasury stock method is used to calculate the net increase in shares outstanding if in-the-money options and warrants were to be exercised. This information is included in the calculation of diluted earnings per share, expanding the number of shares and therefore reducing the amount of earnings per share. The treasury stock method employs the following sequence of assumptions and calculations:
Assume that options and warrants are exercised at the beginning of the reporting period. If they were actually exercised later in the reporting period, use the actual date of exercise.
The proceeds garnered by the presumed option or warrant exercise is assumed to be used to purchase common stock at the average market price during the reporting period.
The difference between the number of shares assumed to have been issued and the number of shares assumed to have been purchased is then added to the denominator of the computation of diluted earnings per share.
Related AccountingTools Course
Example of the Treasury Stock Method
Yellow Corporation earns a net profit of $200,000, and it has 5,000,000 common shares outstanding that sell on the open market for an average of $12 per share. In addition, there are 300,000 options outstanding that can be converted to Yellow’s common stock at $10 each. Yellow’s basic earnings per share is $200,000 ÷ 5,000,000 common shares, or $0.0400 per share.
Yellow’s controller wants to calculate the amount of diluted earnings per share. To do so, he follows these steps:
Calculate the number of shares that would have been issued at the market price. Thus, he multiplies the 300,000 options by the average exercise price of $10 to arrive at a total of $3,000,000 paid to exercise the options by their holders.
Divide the amount paid to exercise the options by the market price to determine the number of shares that could be purchased. Thus, he divides the $3,000,000 paid to exercise the options by the $12 average market price to arrive at 250,000 shares that could have been purchased with the proceeds from the options.
Subtract the number of shares that could have been purchased from the number of options exercised. Thus, he subtracts the 250,000 shares potentially purchased from the 300,000 options to arrive at a difference of 50,000 shares.
Add the incremental number of shares to the shares already outstanding. Thus, he adds the 50,000 incremental shares to the existing 5,000,000 to arrive at 5,050,000 diluted shares.
Based on this information, the controller arrives at diluted earnings per share of $0.0396, for which the calculation is:
$200,000 Net profit ÷ 5,050,000 Common shares
When to Use the Treasury Stock Method
This is a required calculation for a publicly-held company, since all public entities must report their diluted earnings per share on the face of the income statement. The only exception is when a business has such a simple capital structure that the diluted earnings per share figure is the same as its basic earnings per share. A simple capital structure means that a business has only issued common stock; there are no preferred stock, options, or warrants outstanding.