Reverse treasury stock method

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:

  1. 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.
  2. Assume that these proceeds are used to buy back the required number of shares.
  3. 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:

  1. Armadillo assumes that it has issued 1,500 shares at $20.
  2. The company assumes that the “issuance” of 1,500 shares is used to meet the repurchase obligation of $30,000.
  3. 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.