Intermediate Accounting, Chapter 16, Kieso

Convertible bonds

- can be changed into other corporate securities during some specified period of time after issuance.

1. Benefit of a bond (guaranteed interest and principal)

and

2. Privilege of exchanging it for stock (at the holder's option)

Two main reasons corporations issue convertibles

1. raise equity capital without giving up more ownership control than necessary at point of issuance

2. to obtain debt financing at cheaper rates

The accounting for convertible debt involves reporting issues at the time of (1) issuance, (2) conversion, and (3) retirement.

J.E. convertible bond

Cash XX (FMV)

Discount on bond payable XX

Bond payable XXX (par value of bond)

FMV = $4,000,000 par value amount * at 99% for cash = $3,960,000

Discount on bond payable = plug of par value - FMV

**Discount on bond payable is a debit account **

At time of conversion

Companies use the book value method when converting bonds.

When the debt-holder converts the debt to equity, the issuing company recognizes no gain or loss upon conversion.

** possible MC question **

J.E. for conversion of bonds

1. Reverse/remove bond par value and any unamortized discount or premium.

2. allocate at par

Bond payable XX (at par)

Discount on bond payable XXX

Common Stock XXX

P.I.C. - CS XXX (plug)

Discount on bond payable - problem says discount amount

Common stock calculation = outstanding shares how many being converted into = # of new shares par value = common stock amount.

Induced Conversion

-Issuer wishes to encourage prompt conversion.

-Issuer offers additional consideration, called "sweetener"

-Sweetener is an expense on the current period.

JE for conversion of convertible bond

Problem says "agreed to pay the bondholders $70,000 to convert"

Debt conversion expense $70,000

----Cash $70,000

Retirement of Convertible Debt

- Recognized same as retiring debt that is not convertible.

- Difference between the cash acquisition price and carrying amount should be reported as gain or loss in the income statement.

* MC question*

convertible preferred stock

- gives holders the option to exchange their preferred shares for common shares at a specified rate

- Classified as part of stockholders' equity, unless mandatory redemption exists.

- No theoretical justification for recognizing a gain or loss when exercised.

J.E. for convertible preferred stock

1. remove PS at par and PIC PS

2. allocate at par

Preferred stock XX ($ par value PS*conversion #)

PIC - PS XX (original PV-$PV above * conversion#)

----- CS XXX (issued shares*CS PV)

----- PIC CS XXX (plug)

Stock warrants

Warrants are certificates entitling the holder to acquire shares of stock at a certain price within a stated period.

Normally arises under three situations:

1) To make the security more attractive.

2) Existing stockholders have a preemptive rights to purchase common stock first.

3) To executives and employees as a from of compensation.

stock warrants issued with other securities

Basically long-term options to buy common stock at a fixed price.

- Generally life of warrants is 5 years, occasionally 10 years.

- proceeds allocated between the two securities.

- Allocation based on FMVs.

Two methods of allocation:

1) proportional method

2) Incremental method

proportional method

Determine:

1. the value of the bonds without the warrants, and

2. value of the warrants.

- allocates the proceeds using the proportion of the two amounts, based on FVs.

Calculation of proportional method

1) determine allocation percentage based on FMV of each security

2) allocate the lump sum based on FMV

3) determine bond discount or premium.

Bonds w/o warrants

#amount price (%) = TV of bonds -- alloc%

Bonds Warrants Bond FV

Issue $ Allocated

Alloc % ____________ _______________ Discount

J.E. issuance of proportional method

Cash XX (always at FMV at issuance)

Discount bond value XX (bond FV-allocated)

----- Bond payable (at par) XXX

----- PIC (state warrants) XXX (plug)

J.E. exercising of proportional method

1) recognize cash received upon conversion

2) reverse what was converted

3) allocate at par

Cash XX (exercised #*$ per share)

PIC - warrants XX (Allocation total)

----CS XXX (exercised # *par value)

---- PIC CS XXX (plug)

detachable warrants

involves two securities.

1) debt security.

2) warrant to purchase common stock.

nondetachable warrants

1) Do not require an allocation of proceeds between the bonds and the warrants

2) Companies record the entire proceeds as debt

Stock right

existing stockholders have the right (preemptive privilege) to purchase newly issued shares in proportion to their holdings

- price is normally less than current price of the shares

- companies make only a memorandum entry

Stock option

Gives key employees the option to purchase common stock at a given price over an extended period of time.

Effective compensation programs are ones that:

1. base compensation on performance

2. motivate employees

3. help retain executives and recruit new talent

4. SAVE CASH

Measurement - stock compensation

-GAAP requires companies to recognize compensation cost using the fair-value method.

-Under the fair-value method, companies use acceptable option-pricing models to value the options at the date of grant.

Recognition - stock compensation

Determining expense

- compensation expense based on the FV of the options expected to vest on the date they grant the options to the employee(s) (I.e. the grant date)

Allocating compensation expense

- recognizes compensation expense in the periods in which its employees perform the service - the service period (1-5 years).

vesting period = service period

J.E. to recognize stock based compensation expense

service/vesting period is 2 years in this example

1st year

Compensation expense XX (comp exp $/2)

--- PIC stock options XXX

2nd year

same entry

3rd year

no entry

J.E. to exercise stock based compensation expense

1) recognize cash received upon exercise

2) reverse or remove what was converted

3) allocate at par

Cash XX (exercise #*option strike $ per share)

PIC stock options XX (comp exp*% of options)

---- CS XXX (exercise #*par )

---- PIC CS XXX (plug)

J.E. to expire stock based compensation expense

if executives fail to exercise the remaining stock options before their expiration date, the company records the following at the date of expiration:

PIC stock options XX (comp exp*%not exercised)

---- PIC expired stock options XXX (same amount)

A company does not adjust compensation expense upon expiration of the options.

If an employee forfeits (leaves) a stock option the company should adjust the estimate of compensation expense recorded in the current period (as a change in estimate).

Restricted Stock Plans

transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs

Major advantages:

1. never becomes completely worthless (unless it goes bankrupt)

2. generally results in less dilution to existing stockholders.

3. better aligns employee incentives with company incentives.

J.E. of restricted stock

At grant date:

Unearned compensation XX (shares issued*FV)

--- Common Stock XXX (shares issued*PV)

--- PIC CS XXX (plug)

End of year: (same entry throughout the vesting period)

Compensation expense (amount above/vesting period)

--- Unearned compensation XXX

Unearned Compensation

Unearned compensation represents the cost of services yet to be performed, which is not an asset.

Unearned compensation is reported as a component of stockholders' equity in the balance sheet.

Note this is different from stock options ... no entry at grant date as could be worthless.

J.E. of restricted stock (if forfeit)

Since employee left before vesting, none of the sahres are issued and the expense is reversed.

Common Stock XX (reverse)

PIC CS - same amount as the grant date amount

--- Compensation expense (Dec amount * how many years employee was therer)

--- Unearned compensation (rest of the compensation amount minus Compensation expense)

Earnings Per Share (EPS)

measures the net income earned on each share of common stock

- Companies report EPS only for common stock

- When the income statement contains intermediate components, such as discontinued operations, companies should disclose EPS for each component.

EPS - Simple capital structure

Simple structure - common stock; no potentially dilutive securities

Complex structure - includes securities that could dilute earnings per common share (stock options, convertible)

"Dilutive" means the ability to influence the EPS in a downward direction. (could reduce the EPS)

BASIC or Common EPS

Preferred stock dividends

Subtracts the current-year preferred stock dividend from net income to arrive at income available to common stockholders

EPS = ----------------------------------------

Preferred dividends are subtracted on cumulative preferred stock, whether declared or not.

Weighted average number of shares outstanding WAS o/s

Companies must weight the shares by the fraction of the period they are outstanding.

When stock dividends or share splits occur, companies need to restate the shares outstanding before the share dividend or split.

WAS o/s computation

DON'T USE ENDING BALANCE, HAVE TO USE WEIGHTED AVERAGE!!!

Dates o/s shares o/s mnth/yr weighted shares

WAS o/s

Dilutive EPS

Complex capital structure exists when a business has

- convertible securities

- options, warrants, or other rights

that upon conversion or exercise could dilute EPS

Company generally reports both basic and diluted EPS.

Includes the effect of all potential dilutive CS that were o/s during the period

Companies will not report diluted EPS if the securities in their capital structures are antidilutive.

Diluted EPS formula

[(net income - preferred dividends + interest (net of tax) )

/

Weighted avg # of shares o/s +potentially dilutive CS

Convertible Securities

Measure the dilutive effects of potential conversion on EPS using the if-converted method.

This method for a convertible bond assumes

1. the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and

2. the elimination of related interest, net of tax.

if-converted method

- When calculating Diluted EPS, begin with basic EPS.

- calculate diluted EPS and make sure it is less than basic EPS to continue.

- add up top numbers across and then bottom numbers across. Divide to get the diluted EPS.

What the diluted EPS means:

- if people convert, it will be a lower EPS.

- As an investor, need to find out what would happen if everyone converted.

Diluted EPS - Options and Warrants

Measure the dilutive effects of potential conversion using the treasury-stock method

This method assumes:

(1) the exercise the options or warrants at the beginning of the year (or date of issue if later), and

(2) that the company uses those proceeds to purchase common stock for the treasury.

** options are always dilutive **

Treasury Stock method formula

Proceeds of shares issued = $X (o/s*exercise$

--------------------------------------------------

Purchase price for Treasury shares = $ (FMV)

= shares consumed by exercise proceeds (a)

Shares assumed issued = o/s (b)

Incremental share increase (b-a)

EPS Presentation and Disclosure

A company should show per share amounts for:

- income from continuing operations,

- income before extraordinary items, and

- NI

Per share amounts for a discontinued operation or an extraordinary item should be presented on the face of the income statement or in the notes.