Module 1 - Dilutive Securities

What is dilution?

A decrease in ownership percentage when additional common shares are issued.

What are dilutive securities?

Financial instruments that can increase the number of common shares outstanding.

Name 3 types of dilutive securities.

Convertible bonds; Convertible preferred stock; Stock warrants

What is the difference between convertibles and warrants?

Convertibles do not involve a cash exchange. Warrants require cash to exercise.

Shares of Convertible Bonds Issued Formula

Shares = # bonds x conversion rate

Common Stock Recorded Formula

Common stock = shares x par value

Carrying Value of Bonds (with a Discount) Formula

Carrying Value = Face value - Discount

Additional Paid-in Capital of Bonds Converted Formula

APIC = Carrying value - Common Stock

Additional Paid-in Capital (Preferred Conversion) Formula

APIC = Total transferred - Common stock

Discount on Bonds Payable Formula

Discount = Face value - Cash

Proportional Allocation Formula

Allocated = (Fair value of component ÷ Total Fair value) x Proceeds

Incremental Method Rule

Assign known Fair value first; plug remainder to unknown

Interest Formula

Interest = Face x Rate x Time

Partial Discount Amortization Formula

Amortization = Full amortization x (months ÷ 6)

Convertible Bond Issuance Entry

Dr Cash

Dr Discount

Cr Bonds Payable

Convertible bond conversion (book value) Entry

Dr Bonds Payable

Cr Discount (or Dr Premium)

Cr Common Stock

Cr APIC

Convertible preferred stock conversion Entry

Dr Preferred Stock

Dr APIC—Preferred

Cr Common Stock

Cr APIC—Common

Detachable warrants Entry

Dr Cash

Dr Discount

Cr Bonds Payable

Cr PIC—Warrants

Nondetachable warrants entry

Dr Cash

Dr Discount

Cr Bonds Payable

Induced conversion Entry

Dr Debt Conversion Expense

Dr Bonds Payable

Cr Discount

Cr Common Stock

Cr APIC

Cr Cash

Bond interest Entry (issued between dates)

Dr Interest Expense

Dr Interest Payable

Cr Discount (amortization)

Cr Cash

Steps for bond conversion

1. Remove bonds payable

2. Remove discount/premium

3. Compute shares

4. Record common stock at par

5. Plug APIC

Steps for preferred conversion

1. Remove preferred stock

2. Remove APIC—preferred

3. Record common stock

4. Plug APIC

Steps for proportional allocation method (detachable warrants)

1. Compute total FV

2. Compute ratios

3. Allocate proceeds

4. Compute discount

5. Record entry

Steps for incremental allocation method (detachable warrants)

1. Assign known FV

2. Remainder = other component

3. Compute discount

4. Record entry

Steps for bonds issued between dates

1. Compute accrued interest

2. Compute full cash interest

3. Compute discount amortization

4. Adjust for partial period

5. Remove interest payable

What does “issued between dates” mean?

Buyers pay accrued interest from last interest date to issue date

Why is Interest Payable used in entries for bonds issued between dates?

Because the company owes back the interest collected at issuance

Should you use market value for conversions?

NO (book value method ignores market value)

How do you remove discount during conversion?

CREDIT it

Allocation for Detachable vs nondetachable warrants

• Detachable → allocate

• Nondetachable → do NOT allocate

When do you use proportional method in detachable warrants?

When BOTH fair values are known

When do you use incremental method in detachable warrants?

When only one fair value is known

Does cash interest = interest expense?

NO (must adjust for discount + interest payable)

Induced conversion → expense or equity?

EXPENSE

Can bonds still have a discount after being issued above par?

YES if part of proceeds is allocated to warrants

First step in any problem

Identify the instrument (bond, preferred, warrant)

Second step in any problem

Identify the event (issue, convert, allocate, interest)

Conversion always uses what method?

Book value method

Warrants require what key decision?

Proportional vs incremental

Quick bond conversion rule

Remove debt → add equity → no gain/loss

Quick warrant rule

Detachable = split; nondetachable = don't split

Bonds issued between dates survival tip

Separate: interest, accrued interest, amortization

You see “convertible bonds converted into stock.” What method do you use?

Book value method

You see market value of stock during conversion. What do you do?

Ignore it completely

You see “convertible preferred stock converted.” What method?

Book value method

You see “detachable warrants.” What must you do first?

Decide: proportional vs incremental method

You see both fair values for bonds and warrants. What method?

Proportional method

You see only ONE fair value given for bonds or warrants. What method?

Incremental method

You see “nondetachable warrants.” What do you do?

Do NOT allocate; treat as debt only

You see “issued between dates.” What is your FIRST step?

Compute accrued interest

You see “extra payment to induce conversion.” What must be recorded?

Debt Conversion Expense

What are the 5 steps for converting bonds?

1. Remove bonds payable

2. Remove discount/premium

3. Compute shares issued

4. Record common stock at par

5. Plug APIC

What are the steps for preferred conversion?

1. Remove preferred stock

2. Remove APIC—preferred

3. Record common stock

4. Plug APIC—common

Steps for proportional method

1. Compute total FV

2. Compute ratios

3. Allocate proceeds

4. Compute bond discount

5. Record entry

Steps for incremental method

1. Assign known FV

2. Allocate remainder

3. Compute discount

4. Record entry

Full procedure for bonds issued between dates

1. Find last interest date

2. Compute accrued interest

3. Compute full interest payment

4. Compute discount amortization

5. Adjust for partial period

6. Remove Interest Payable

7. Solve for Interest Expense

Shares from bonds formula

Shares = bonds × conversion ratio

Common stock amount formula

Common stock = shares × par

Carrying value (discount) formula

Face – discount

APIC (conversion) formula

APIC = Carrying value – Common stock

Discount formula (normal issue)

Face – Cash

Discount formula (warrants case)

Face – allocated bond portion

Proportional allocation formula

Allocated = (FV ÷ total FV) × proceeds

Incremental formula

Unknown = Total proceeds – Known FV

Accrued interest formula

Face × rate × (months ÷ 12)

Cash interest formula

Face × rate × 6/12

Discount amortization formula

Total discount ÷ number of periods

Partial amortization formula

Full amort × (months ÷ 6)

You see bond conversion with discount — what happens to discount?

CREDIT it

You see bond conversion with premium — what happens?

DEBIT it

You see detachable warrants — what must appear in entry?

Paid-in Capital—Stock Warrants

You see nondetachable warrants — what should NOT appear?

No warrant equity account

You see induced conversion — what extra account appears?

Debt Conversion Expense

You see bond issued between dates-type interest entry — which accounts are always involved?

• Interest Expense

• Interest Payable

• Discount/Premium

• Cash

What happens if you use market value in bond conversion?

You get it WRONG (book value only)

What mistake occurs if you forget to remove Interest Payable in Q4?

Interest expense is overstated

What happens if you forget to use partial amortization?

Discount amortization is incorrect

What happens if you allocate warrants when they’re nondetachable?

Entire entry is wrong

What happens if you use proportional when only one FV is given?

Wrong method → wrong allocation

What happens if you forget to remove APIC—Preferred in conversion?

Entry won’t balance correctly

Can bonds originally issued above par still show a discount later?

YES (after warrant allocation)

Bonds issued at 102 with detachable warrants, and both FVs given — what do you do?

Use proportional method and allocate proceeds

Bonds issued at 102 but warrant FV unknown — what do you do?

Use incremental method

You see: “converted after amortization entries recorded” — what does that mean?

Use updated (remaining) discount

Bonds dated April 1, issued June 1 — what adjustment is required?

Accrued interest collected at issuance

Why is Interest Payable debited at first interest payment?

It reverses the accrued interest collected at issuance

What 3 components determine interest expense in bonds issued between dates-type problems?

• Cash interest

• Discount amortization

• Interest payable adjustment

First question to ask yourself in ANY problem

What type of instrument is this?

Second question

What event is happening?

Third question

Which method applies?