Download - 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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ACTG 6580

Chapter 16 – Dilutive Securities

16-2

Share OptionsConvertible Securities

Preference Shares

Should companies report these instruments as a liability

or equity?

DILUTIVE SECURITIES AND COMPENSATION PLANS

Debt and Equity

LO 1

16-3

Distinguishing Financial Liabilities From Equity Instruments

Debt/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)

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Distinguishing Financial Liabilities From Equity Instruments – Substance Over Form Test

Equity 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 issuer’s own equity instruments

16-5

Debt versus Equity

Instruments 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

16-6

Classification, Recognition and Measurement

Classification of debt versus equity

IFRS

► 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 entity’s 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 GAAP► Classification 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 entity’s shares.

► Instruments requiring an entity to repurchase its own stock for cash or other assets.

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(at the holder’s 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 Debt

LO 1

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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 Debt

LO 1

16-9

Convertible debt is accounted for as a compound instrument.

Companies use the “with-and-without” method to value

compound instruments.

Accounting for Convertible Debt

Convertible Debt

LO 1

ILLUSTRATION 16-1Convertible DebtComponents

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Implementation of the with-and-without approach:

1. First, determine total fair value of convertible debt with both

the liability and equity component.

2. Second, determine liability component by computing net

present value of all contractual future cash flows discounted

at the market rate of interest.

3. 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 Debt

Convertible Debt

LO 1

16-11

Accounting at Time of Issuance

Illustration: 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 Debt

LO 1

16-12

Accounting at Time of Issuance

Convertible Debt

LO 1

ILLUSTRATION 16-2Time Diagram forConvertible Bond

ILLUSTRATION 16-3Fair Value of Liability Component of Convertible Bond

ILLUSTRATION 16-4Equity Component ofConvertible Bond

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Cash 2,000,000

Bonds Payable 1,805,626

Share Premium—Conversion Equity 194,374

Journal Entry

Convertible Debt

LO 1

Accounting at Time of Issuance ILLUSTRATION 16-3Fair Value of Liability Component of Convertible Bond

ILLUSTRATION 16-4Equity Component ofConvertible Bond

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Settlement of Convertible Bonds

Repurchase at Maturity. If the bonds are not converted at

maturity, Roche makes the following entry to pay off the

convertible debtholders.


Cash 2,000,000

NOTE: The amount originally allocated to equity of €194,374 either remains

in the Share Premium—Conversion Equity account or is transferred to the

Share Premium—Ordinary account.

Convertible Debt

LO 1

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Conversion of Bonds at Maturity. If the bonds are converted

at maturity, Roche makes the following entry.



Share Capital—Ordinary 500,000

Share Premium—Ordinary 1,694,374

NOTE: The amount originally allocated to equity of €194,374 is transferred to

the Share Premium—Ordinary account.

Convertible Debt

LO 1

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Conversion of Bonds before Maturity.

Convertible Debt

LO 1

ILLUSTRATION 16-5Convertible BondAmortization Schedule

16-17


Conversion of Bonds before Maturity. Assuming that Roche

converts its bonds into ordinary shares on December 31, 2016.



Share Capital—Ordinary 500,000

Share Premium—Ordinary 1,588,838

NOTE: The amount originally allocated to equity (€194,374) is transferred to

the Share Premium—Ordinary account.

Convertible Debt

LO 1

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Repurchase 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,

1. The difference between the consideration allocated to the

liability component and the carrying amount of the liability is

recognized as a gain or loss, and

2. The amount of consideration relating to the equity

component is recognized (as a reduction) in equity.

Convertible Debt

LO 1

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Repurchase 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 Debt

LO 1

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First, determine the gain or loss on the liability component.ILLUSTRATION 16-6

ILLUSTRATION 16-7Next, determine any adjustment to the equity.

Convertible Debt

LO 1

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ILLUSTRATION 16-6 & 7




Loss on Repurchase 10,436

Cash 1,965,000

Journal Entry

Convertible Debt

LO 1

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Convertible Preference Shares

Convertible 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 2

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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) 200,000

Share Capital—Preference (1,000 x €1) 1,000



LO 2

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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 Capital—Preference 1,000


Share Capital—Ordinary (1,000 x 25 x €2) 50,000

Share Premium—Ordinary 150,000


LO 2

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Illustration: If the convertible preference shares are

repurchased at their fair value instead of converted, Morse

makes the following entry.

Share Capital—Preference 1,000


Retained Earnings 210,000

Cash 410,000

Any excess paid above the book value of the convertible

preference shares is often debited to Retained Earnings.


LO 2

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Mandatorily Redeemable Preferred Stock

Must be treated as a liability because There is an obligation to redeem the preferred

shares The 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.

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DILUTIVE SECURITIES AND EARNINGS PER SHARE

Both 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 INSIGHTS

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Relevant Facts

Differences

• Under U.S. GAAP, all of the proceeds of convertible debt are recorded as

long-term debt. Under IFRS, convertible bonds are “bifurcated”—separated

into the equity component (the value of the conversion option) of the bond

issue and the debt component.


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On the Horizon

The 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.


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Homework

E16-1, E16-2, E16-3

DUE THURSDAY, OCTOBER 29

Download - 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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