The reverse treasury stock method is used to calculate the effect of a put option on the diluted earnings per share calculation of a publicly-held entity.
A business may be party to a contract that requires it to buy back its own stock from a shareholder. This type of arrangement is called a put option. If the effect of a put option is dilutive (which occurs when the exercise price is higher than the average market price in a reporting period), it must be included in the diluted earnings per share calculation. The calculation of the effect of a put option is measured using the reverse treasury stock method, which involves the following steps:
- Assume that enough shares were issued by the company at the beginning of the period at the average market price to raise sufficient funds to satisfy the put option contract.
- Assume that these proceeds are used to buy back the required number of shares.
- Include in the denominator of the diluted earnings per share calculation the difference between the numbers of shares issued and purchased in steps 1 and 2.
For example, a third party exercises a written put option that requires Armadillo Industries to repurchase 1,000 shares from the third party at an exercise price of $30. The current market price is $20. Armadillo uses the following steps to compute the impact of the written put option on its diluted earnings per share calculation:
- Armadillo assumes that it has issued 1,500 shares at $20.
- The company assumes that the “issuance” of 1,500 shares is used to meet the repurchase obligation of $30,000.
- The difference between the 1,500 shares issued and the 1,000 shares repurchased is added to the denominator of Armadillo’s diluted earnings per share calculation.