ACC422 Exam 1

What is a Convertible Bond?

Hybrid financial instrument (mixed attributes debt and equity) that pays interest and can be converted to common stock

What is the motivation for convertible bonds

• Raises capital at lower interest rates

• Better Cash Flows

• Higher Net Income

• Investor: Gets benefit to convert

Convertible Bonds: Issuance

• Similar to accounting for straight debt

• WE DO NOT BIFURCATE UNDER GAAP

  • Equity is not a given, so only recognize debt

Convertible Bonds: Conversion

Book Value of the bonds is removed and replaced with common stock and PIC

Conversion is initiated by security holder

Conversion of Debt: Example

Given:

• One $1,000 bond, issued at $45 premium

• The bond is convertible into 10 common shares of $10 par

• At conversion: unamortized premium is $30

Record the conversion using the book value method.

• DR: BP 1,000 (ALWAYS AT PAR)

• DR: Premium on BP 30

  • CR: Common Stock 100

  • CR: Paid in Capital 930

Downside of Convertible Bonds

Potential to dilute ownership

Bifurcate

Recognize both equity and debt

• GAAP does not, International does for hybrid financial instruments

2 Examples of Hybrid Financial Instruments

• Stock Warrants

• Convertible Bonds

Stock Warrants

• Entitle the holder to acquire additional common stock within a stipulated period and a specified price

• Dilutive effect on EPS

• Cash received by issuer upon exercise

• May be issued independently or with another security

• Also known as Stock Options

What can stock warrants “be” and what are the allocation methods

• Detachable (Can be traded Independently)

  • Proportional OR Incremental Method

  • EX: Food voucher to use anytime with purchase of game ticket

• Non Detachable (Cannot be separated from their underlying security)

  • No Allocation

  • EX: Food voucher to ONLY be used at the game you got the ticket for

Are Stock Warrants Bifurcated

Yes but ONLY when they are DETACHABLE

Proportional Method Example (Detachable Warrants)

Given:

• Bonds, with a par value of $10,000 and detachable warrants, are sold at par.

• Bonds’ FMV without the warrants is $9,800.

• FMV of warrants is $400.

Allocate the $10,000 to bonds and the detachable warrants. Show JEs

• Allocated to Bonds

  • (9,800 / 10,200 FMV) * 10,000 (Issue) = 9,608

• Allocated to Warrants

  • (400 / 10,200 FMV) * 10,000 (Issue) = 392

• JEs

  • Cash 9,608

  • Discount (BP) 392

    • BP 10,000

  • Cash 392

    • Paid in (Stock Warrants) 392

      • MAKE SURE THAT THIS IS NOT PIC (THIS IS AN EQUITY ACCOUNT)

Stock Compensation plans examples

• Stock Option Plans

• Stock Appreciation Rights

• Restricted Stock

Stock Option Plans: Value of compensation, when is it recognized, JE, cash flows, volatility

• Value

  • FV of the option at the grant date

• Recognized

  • Over the vesting period

• Entry

  • DR: Compensation Expense

    • CR: PIC - Stock Options (EQUITY ACCOUNT)

• Employee Pays Cash

• NO VOLATILITY

How do corps measure Compensation Expense

• Intrinsic method (old)

• FV Method (SFAS 123(R))

Stock Compensation Plans: Controversy

• Use of intrinsic method results in “Overstating” earnings

• Options granted disproportionately to a few top executives

Stock Appreciation Rights: JE, Cash flows, volatility, extra appendix info

• JE

  • DR: Compensation Expense

    • CR: LIABILITY

• Employer pays cash

• Volatile

• Needs chart

Restricted Stock: JE, Cash flows, extra appendix?, liability or equity

• Hybrid of Stock Options and SARS

• JE

  • DR: Unearned compensation

    • Contra Equity^

      • CR: Equity

• Cash Neutral

• Straight Line

• Issues Equity

EPS: Concepts

• Reported on IS and focus of investors

• Dilution means reduction in EPS

• Reduction in EPS results from conversion of other securities into common stock

• SH want to know the extent of reduction in EPS, if dilution takes place

• The issue is conservatism

Basic EPS Equation

EPS = (Net Income - Preferred Dividends) / Weighted Avg Shares Outstanding

Diluted EPS Equation

EPS = ((Net Income - Preferred Dividends) / Weighted Avg Shares Outstanding) - Impact of Convertibles - Impact of Options, Warrants, and Other Dilutive Securities

What is a Simple Capital Structure

• Common stock ONLY with no potentially dilutive securities

Complex Capital Structures

• Potentially dilutive securities such as

  • Convertible bonds or preferred stock

  • Options or Warrants

Securities that could reduce EPS are

Dilutive

Securities that could increase EPS are

Anti Dilutive

Dilutive EPS Methods

• Dilutive effects of convertible securities is measured by

  • If Converted Method

• Dilutive effect of options and warrants is measured by

  • Treasury Stock Method

What do we do when a convertible bond is partially converted 

Multiply by a fraction

Debt Security Categories

• Trading

• AFS

• HTM 

Equity Security Categories  

• Trading

• AFS

• NO HTM BECAUSE NO MATURITY

Trading Securities   

• Recorded at FV

• Used to generate profits in short term differences

• Usually less than 3 minths

• Unrealized gains and losses reported as a part of Net Income

AFS Securities

• Recorded at FV

• MC Changes recorded as a part of Equity

• Differences between the FV and Amtzd. cost are reported as unrealized holding gains and losses (Equity)

• When Realized, gains and losses in FV are reported as a part of Net Income

HTM Securities   

• Recorded at Amortized Cost

• MV Changes Not Recognized

• Investor has BOTH

  • A positive intent to hold the securities

  • The ability to hold them to maturity

Equity Securities

• Represent OWNERSHIP INTEREST such as common and pref. stock

  • Common stock is mandatory

• Include rights to BUY and SELL the ownership interests

• Convertible debt and redeemable pref. stock are NOT equity securities for this purpose

• The extent of ownership in common stock determines the acc treatment

Equity Levels of Influence   

0-20%: Passive

20-50%: Significant

50%+: Control

Accounting treatments for different levels of equity securities   

• Passive

  • FV Method

• Significant

  • Equity Method

• Control

  • Consolidations

Equity Method

• Investor has significant influence

• Investment is initially recorded at cost

• The investments carrying value is increased by investor’s proportionate share of earnings

• The investment’s carrying value is decreased by

  • Investors proportionate share of losses

  • Dividends declared by investee

Equity or Debt?

Stock Options

Convertible Bonds  

Options

• Equity

Conv. Bonds

• For issuing company they are debt instruments

• For investors debt securities

Company decides there was a loss, what should be DEBITED

Unrealized Holding Gain/Loss

Company decided there was a gain, what should be debited

Fair Value Adjustment

Equity Method Formula

Investors Cost of Shares ± % Share of Investee’s net income or net loss ± % share of investee’s cash dividends

How are equity securities assessed?

Portfolio basis, not individual

If we see that a company credits a FV adjustment, what does this show

They had a loss

Why are derivatives important

They are valued at TRILLIONS in the US

Examples of derivatives

Jet fuel

Crypto

Derivatives “Hedge”

Locking in on a price and hedging themselves against risk (Delta jet fuel)

Derivatives “Speculator”

• Not going to actually use jet fuel, but I could temporarily buy and sell them

• Extremely risky, lots of volatility

How are Derivatives recorded?

Like a trading security

• Fair value on the Balance sheet

• Gain/loss on IS

Central Characteristic of Debt, and Examples

MANDATORY

• Bonds

• Redeemable Pref. Stock

10,000 gain on HTM, what do we debit?

No Entry

Central Characteristic of Equity and Examples

OWNERSHIP

• Stock, pref stock, options

What is the difference in dividend accounting for FV and Equity Method

FS Implications
JE’s

• FV Method makes Income go Up

  • DR: Cash (Asset)

    • CR: Dividend Revenue (Income)

• Equity Method makes Assets go Down

  • Return of investment, so equity goes up

    • DR: Cash

      • CR: Equity Investment

What is Revenue   

Inflows of assets or settlements of liabilities from delivering or producing goods

Revenue is recognized when it is BOTH

• Realized or Realizable

• Earned

Revenue: Recognition

The process of formally recording or incorporating an item in the accounts of an entity

Revenue: Realized

When goods and services are exchanged for cash or claims to cash

Cash is in hand

Revenue: Realizable

When assets received in exchange are readily convertible to known amounts of cash

Cash is probable

Revenue: Earned

when a company has accomplished what it must do to be entitled the benefits represented by the revenue, that is, when the earnings process is complete

Product/Service Delivered

What is the revenue standard

ASC 606

5 Step Model

Why is revenue recognition so important

As Revenue INCREASES

Income/EPS INCREASES

Stock Price INCREASES

5 Step Model for ASC 606

1. Identify Contract with Customers

2. Identify the separate performance obligations

3. Determine the transaction price

4. Allocate the transaction price to separate performance obs.

5. Recognize Revenue when each performance ob. is satisfied

CHEN Windows manufactures and sells custom storm windows for

enclosed porches. CHEN also provides installation service for the

windows. CHEN enters into the following contract on June 1, 2025,

with a local homeowner. The customer purchases windows for a price

of $4,700 which includes both the windows and the installation. The

price of the installation service is estimated to have a fair value of

$1,200. The customer pays CHEN $4,000 (which equals the fair value

of the windows: cost = 2300) upon delivery and the remaining

balance upon installation of the windows. The windows are delivered

on August 1, 2025, CHEN completes installation on September 15,

2025, and the customer pays the balance due.

Prepare the journal entries for CHEN in 2025

Step 1: Identify the Contract

• No Entry, neither party has performed under contract

Step 2: Identify Performance Obligations

• Delivery of Windows

• Installation of Windows

Step 3: Determine Price

• Windows = 4,000

• Installation = 1,200

• Total = 5,200

Step 4: Allocate price to performance obligations

• Windows (4,000 / 5,200) * 4,700 = 3,615

• Installation (1,200 / 5,200) * 4,700 = 1,085

• Revenue Recognized = 4,700

Step 5: Revenue Recognition

• August 1

  • DR: Cash 4,000

  • DR: AR 700

    • CR: Unearned Service Revenue 1,085

    • CR: Sales Revenue 3,615

  • DR: COGS 2,300

    • CR: Inventory 2,300

• September 15

  • DR: Cash 700

  • DR: Unearned Service Revenue 1,085

    • CR: Service Revenue (Installation) 1,085

    • CR: AR 700

What type of account is Unearned Revenue?

Liability

Why are warranties important

They determine when expenses or revenues are recognized

What are the 2 types of warranties

• Assurance Type

• Service Type (Sales)

Accounting for Assurance Type Warranty

• DR: Cash

  • CR: Sales Revenue

• DR: Warranty Expense

  • CR: Inventory

• DR: Warranty Expense

  • CR: Warranty Liability

Expense is recognized when the product is sold, not when repaired

Accounting for Service Type Warranty

• DR: Cash

  • CR: Sales Revenue

  • CR: UNEARNED Warranty Revenue

• DR: Warranty Expense

  • CR: Inventory

• DR: Warranty Expense

  • CR: Warranty Liability

When do we use unearned accounts for warranties?

When it is a service type warranty (Extended)

• You pay claims as an expense

Assurance or Manufacturing Type Warranty

• Comes automatically

• Not unearned revenue

• All revenue, you expense claims

Service or Sales Type Warranty

• Buy a warranty plan separately

• Recognized over time

What are the 2 main attributes of Construction Accounting

• Extends more than one Accounting Period

• Material Dollar Amounts

What is the method we use in construction accounting called    

Percentage of Completion Method

Securities and Exchange Commission (SEC)

• Established by Federal Gov

• Deals with accounting and reporting for public companies

• Enforcement authority

Financial Accounting Standards Board (FASB)

• Establish and improve standards of financial accounting and reporting

• FASB

  • Smaller membership

  • Greater Autonomy

  • Increased Independence

  • Broad Representation

FASB Codification

• Creates one level of GAAP, which is considered authoritative

• Goal is to provide authoritative literature all in one place

ASC Citation Format

ASC X (Topic) - X (Subtopic)-X(Section) - X (Subsection/Paragraph)

Accrued Interest

• Bond was not bought when first listed, but interest still obligated (embedded)

3 C’s for EPS importance

• Comparability (across companies)

• Consistency (across time)

• Conservatism (Dilution)

How do dividends and splits affect EPS

• They affect the month they are in and everything before

When do we take off preferred dividends for EPS

• Declared/Cumulative

When doing complex EPS, REMEMBER

Net of tax

EPS will always get a number in denominator divided by what

1,000

Treasury stock method reminder

Top number will be 0

What is the debit account in construction accounting

CIP