Treasury Method

The treasury stock method (TSM) is defined in ASC 260-10 and is the standard technique for including the dilutive impact of options and warrants in diluted EPS calculations. The key insight is that options are not purely additive to share count — when exercised, they bring in cash proceeds that can be used to offset some of the dilution.

The mechanics work as follows. Assume a company has 1 million stock options outstanding with a strike price of $10, and the average stock price for the period is $20. Under TSM: (1) assume all 1 million options are exercised, generating $10 million of proceeds; (2) use those proceeds to repurchase shares at the average market price of $20, buying back 500,000 shares; (3) the net dilutive shares added to the count equals 1,000,000 minus 500,000 = 500,000 shares. The diluted EPS denominator includes these 500,000 incremental shares rather than the full 1 million.

Only in-the-money options (where the strike price is below the average market price) are included in the diluted count. Out-of-the-money options are antidilutive (their inclusion would increase EPS rather than decrease it) and are excluded.

For restricted stock units (RSUs), no exercise price is paid, so TSM still assumes the tax withholding proceeds (for RSUs settled on a net-basis, where the company withholds shares to cover taxes) partially offset the dilution, but the impact is smaller than for options with significant strike prices.

The treasury method differs from the if-converted method, which is used for convertible debt and preferred stock rather than options and warrants.