16-1 ACTG 6580 Chapter 16 – Dilutive Securities. 16-2 Share Options Convertible Securities Preference Shares Should companies report these instruments.

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Financial Accounting and Accounting Standards

(at the holders option)Benefit of a Bond (guaranteed interest and principal)Privilege of Exchanging it for Shares

Bonds which can be changed into other corporate securities are called convertible bonds.+Convertible DebtLO 116-#To raise equity capital without giving up more ownership control than necessary.Obtain debt financing at cheaper rates.

Two main reasons corporations issue convertibles:Convertible DebtLO 116-#Distinguishing Financial Liabilities From Equity InstrumentsDebt/equity distinctions are important affects leverage and solvency ratios, debt covenants, treatment of payments as either interest or dividends & capital adequacy requirements

A substance over form test aims to limit attraction to misclassify many as equity instruments (when they essentially should be classified as liabilities)16-#Distinguishing Financial Liabilities From Equity Instruments Substance Over Form TestEquity instruments need to meet two conditions (A & B)

Part A - An equity instrument must include no contractual obligation to:Deliver financial assets to another entity Exchange assets/liabilities unfavorable to the issuer

Part B The instrument will or may be settled in the issuers own equity instruments

16-#Debt versus EquityInstruments that require settlement with a variable number of shares establish a debtor/creditor relationship and are thus are treated as liabilities. This is true even if the legal form is preferred stock.

Those that require settlement with a fixed number of shares generally establish more of a shareholder relationship and are thus treated as equity.Similar.

IFRSUS GAAP

16-#5Classification, Recognition and MeasurementClassification of debt versus equityIFRS

Classification starts with the definitions.The focus is on whether there is a contractual obligation to deliver cash, other assets or a variable number of the entitys own shares. If such an obligation exists, a liability exists. This is applied to all instruments whether they are loans/bonds or preferred or common stock. Unless the entity has an unconditional right to avoid delivering cash or other financial assets, it is a liability.

US GAAPClassification is addressed on an instrument-by-instrument basis:The legal form often dictates the classification . ASC 480 requires that specific instruments be classified as liabilities, even if they are stock and even if they have characteristics of both debt and equity. Some examples of instruments that must be accounted for as debt include: Mandatorily redeemable shares.Instruments that must be redeemed or repaid using a variable number of the entitys shares. Instruments requiring an entity to repurchase its own stock for cash or other assets.

16-#Convertible debt is accounted for as a compound instrument. Companies use the with-and-without method to value compound instruments.Accounting for Convertible DebtConvertible DebtLO 1

ILLUSTRATION 16-1Convertible DebtComponents16-#Implementation of the with-and-without approach:First, determine total fair value of convertible debt with both the liability and equity component.Second, determine liability component by computing net present value of all contractual future cash flows discounted at the market rate of interest.Finally, subtract liability component estimated in second step from fair value of convertible debt (issue proceeds) to arrive at the equity component. Accounting for Convertible DebtConvertible DebtLO 116-#Accounting at Time of IssuanceIllustration: Roche Group (CHE) issues 2,000 convertible bonds at the beginning of 2015. The bonds have a four-year term with a stated rate of interest of 6 percent and are issued at par with a face value of 1,000 per bond (the total proceeds received from issuance of the bonds are 2,000,000). Interest is payable annually at December 31. Each bond is convertible into 250 ordinary shares with a par value of 1. The market rate of interest on similar non-convertible debt is 9 percent.Convertible DebtLO 116-#Accounting at Time of Issuance

Convertible DebtLO 1ILLUSTRATION 16-2Time Diagram forConvertible Bond

ILLUSTRATION 16-3Fair Value of Liability Component of Convertible BondILLUSTRATION 16-4Equity Component ofConvertible Bond

16-#Cash 2,000,000Bonds Payable 1,805,626Share PremiumConversion Equity 194,374Journal EntryConvertible DebtLO 1Accounting at Time of Issuance

ILLUSTRATION 16-3Fair Value of Liability Component of Convertible BondILLUSTRATION 16-4Equity Component ofConvertible Bond

16-#Settlement of Convertible BondsRepurchase at Maturity. If the bonds are not converted at maturity, Roche makes the following entry to pay off the convertible debtholders.Bonds Payable 2,000,000Cash 2,000,000NOTE: The amount originally allocated to equity of 194,374 either remains in the Share PremiumConversion Equity account or is transferred to the Share PremiumOrdinary account.Convertible DebtLO 116-#Settlement of Convertible BondsConversion of Bonds at Maturity. If the bonds are converted at maturity, Roche makes the following entry.Share PremiumConversion Equity 194,374Bonds Payable 2,000,000Share CapitalOrdinary 500,000Share PremiumOrdinary 1,694,374NOTE: The amount originally allocated to equity of 194,374 is transferred to the Share PremiumOrdinary account.Convertible DebtLO 116-#Settlement of Convertible BondsConversion of Bonds before Maturity. Convertible DebtLO 1

ILLUSTRATION 16-5Convertible BondAmortization Schedule16-#Settlement of Convertible BondsConversion of Bonds before Maturity. Assuming that Roche converts its bonds into ordinary shares on December 31, 2016. Share PremiumConversion Equity 194,374Bonds Payable 1,894,464Share CapitalOrdinary 500,000Share PremiumOrdinary 1,588,838NOTE: The amount originally allocated to equity (194,374) is transferred to the Share PremiumOrdinary account.Convertible DebtLO 116-#Settlement of Convertible BondsRepurchase before Maturity. Roche determines the fair value of the liability component of the convertible bonds at December 31, 2016, and then subtracts the fair value of the convertible bond issue (including the equity component) to arrive at the value of the equity. Then,The difference between the consideration allocated to the liability component and the carrying amount of the liability is recognized as a gain or loss, andThe amount of consideration relating to the equity component is recognized (as a reduction) in equity. Convertible DebtLO 116-#Settlement of Convertible BondsRepurchase before Maturity. Assume:Fair value of the convertible debt (including both liability and equity components), based on market prices at December 31, 2016, is 1,965,000.The fair value of the liability component is 1,904,900. This amount is based on computing the present value of a non-convertible bond with a two-year term (which corresponds to the shortened time to maturity of the repurchased bonds.)Convertible DebtLO 116-#

Settlement of Convertible BondsFirst, determine the gain or loss on the liability component.ILLUSTRATION 16-6ILLUSTRATION 16-7Next, determine any adjustment to the equity.Convertible DebtLO 1

16-#ILLUSTRATION 16-6 & 7Settlement of Convertible BondsBonds Payable 1,894,464Share PremiumConversion Equity 60,100Loss on Repurchase 10,436Cash 1,965,000Journal EntryConvertible DebtLO 1

16-#Convertible Preference SharesConvertible preference shares include an option for the holder to convert preference shares into a fixed number of ordinary shares.Convertible preference shares are reported as part of equity.When preference shares are converted or repurchased, there is no gain or loss recognized.

LO 216-#Illustration: Morse Company issues 1,000 convertible preference shares that have a par value of 1 per share. The shares were issued at a price of 200 per share. The journal entry to record this transaction is as follows.Cash (1,000 x 200) 200,000Share CapitalPreference (1,000 x 1) 1,000Share PremiumConversion Equity 199,000Convertible Preference SharesLO 216-#Illustration: If each share is subsequently converted into 25 each ordinary shares (2 par value) that have a fair value of 410,000, the journal entry to record the conversion is as follows.Share CapitalPreference 1,000Share PremiumConversion Equity 199,000Share CapitalOrdinary (1,000 x 25 x 2) 50,000Share PremiumOrdinary 150,000Convertible Preference SharesLO 216-#Illustration: If the convertible preference shares are repurchased at their fair value instead of converted, Morse makes the following entry.Share CapitalPreference 1,000Share PremiumConversion Equity 199,000Retained Earnings 210,000Cash 410,000Any excess paid above the book value of the convertible preference shares is often debited to Retained Earnings.Convertible Preference SharesLO 216-#Mandatorily Redeemable Preferred StockMust be treated as a liability becauseThere is an obligation to redeem the preferred sharesThe entity does not have an unconditional right to avoid delivering cash or other financial assets, so it is a liability. Dividends would be treated as interest expense.

16-#DILUTIVE SECURITIES AND EARNINGS PER SHAREBoth the FASB and the IASB are working on a standard related to the distinction between liabilities and equity. The U.S. GAAP approach to account for certain dilutive securities, such as convertible debt and debt issued with share warrants, is different than IFRS. The accounting and disclosure requirements for accounting for share options and EPS computations are similar between U.S. GAAP and IFRS.

GLOBAL ACCOUNTING INSIGHTS16-#Relevant FactsDifferencesUnder U.S. GAAP, all of the proceeds of convertible debt are recorded as long-term debt. Under IFRS, convertible bonds are bifurcatedseparated into the equity component (the value of the conversion option) of the bond issue and the debt component.

GLOBAL ACCOUNTING INSIGHTS16-#On the HorizonThe FASB has been working on a standard that will likely converge to IFRS in the accounting for convertible debt. Similar to the IASB, the FASB is examining the classification of hybrid securities; the IASB is seeking comment on a discussion document similar to the FASB Preliminary Views document, Financial Instruments with Characteristics of Equity. It is hoped that the Boards will develop a converged standard in this area.

GLOBAL ACCOUNTING INSIGHTS16-#HomeworkE16-1, E16-2, E16-3DUE THURSDAY, OCTOBER 2916-#

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