Participating Securities
Participating securities under ASC 260 are securities that contractually entitle their holders to participate in dividends or distributions of undistributed earnings alongside common shareholders, requiring the use of the two-class method to allocate earnings between common and participating security holders for EPS purposes.
The concept of participating securities is fundamental to understanding how the two-class EPS method works and why certain companies report EPS on a more complex basis. A security participates in earnings when it has contractual rights that go beyond a fixed dividend — specifically, when it would receive additional distributions alongside common shareholders if dividends above a threshold are declared or if the company distributes undistributed earnings.
The most common examples of participating securities include convertible preferred stock that carries the right to receive dividends on an as-converted basis before any dividends are declared on common stock, and unvested restricted stock units or restricted shares that carry non-forfeitable dividend rights (meaning the holder receives dividends declared on the underlying shares even before the awards vest). In the latter case, FASB has determined that these unvested shares are participating because their holders receive actual dividends alongside common shareholders, regardless of vesting.
A security must meet two criteria to be classified as participating: (1) it must have the contractual right to participate in dividends on a basis other than a fixed percentage of the security's liquidation or face value, and (2) it must participate in undistributed earnings — not just in declared dividends up to a capped amount. Securities that receive only a fixed dividend (non-participating preferred stock) are not participating securities and do not require the two-class method — their dividends are simply deducted from the numerator of basic EPS.
The distinction between participating and non-participating matters enormously for companies that generate substantial earnings but pay limited dividends. When undistributed earnings are large relative to declared dividends, the allocation under the two-class method can reduce EPS attributable to common shareholders significantly compared to a calculation that does not segregate participating security holders.
For investors, participating securities disclosures are most significant in the context of companies that have raised capital through preferred stock rounds (common pre-IPO) or have structured equity compensation plans that include dividend-equivalent rights on unvested awards. After a company completes an IPO and preferred stock converts to common, the participating security dynamic often disappears — which is one reason post-IPO EPS may be difficult to compare with pre-IPO EPS on a pro-forma basis.