Dilutive Securities and Earnings per Share

Solutions Manual and Test Bank Intermediate Accounting Kieso Weygandt Warfield 14th edition

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Chapter 16 Dilutive Securities and Earnings per Share

QUESTIONS

1. What is meant by a dilutive security?
2.
Briefly explain why corporations issue convertible securities.
3.
Discuss the similarities and the differences between convertible debt and debt issued with stock warrants.
4.
Bridgewater Corp. offered holders of its 1,000 convertible bonds a premium of $160 per bond to induce conversion into shares of its common stock. Upon conversion of all the bonds, Bridgewater Corp. recorded the $160,000 premium as a reduction of paid-in capital. Comment on Bridgewater’s treatment of the $160,000 “sweetener.”
5.
Explain how the conversion feature of convertible debt has a value (a) to the issuer and (b) to the purchaser.
6.
What are the arguments for giving separate accounting recognition to the conversion feature of debentures?
7.
Four years after issue, debentures with a face value of $1,000,000 and book value of $960,000 are tendered for conversion into 80,000 shares of common stock immediately after an interest payment date. At that time, the market price of the debentures is 104, and the common stock is selling at $14 per share (par value $10). The company records the conversion as follows.
8.
On July 1, 2012, Roberts Corporation issued $3,000,000 of 9% bonds payable in 20 years. The bonds include detachable warrants giving the bondholder the right to purchase for $30 one share of $1 par value common stock at any time during the next 10 years. The bonds were sold for $3,000,000. The value of the warrants at the time of issuance was $100,000. Prepare the journal entry to record this transaction.
9.
What are stock rights? How does the issuing company account for them?
10.
Briefly explain the accounting requirements for stock compensation plans under GAAP.
11.
Cordero Corporation has an employee stock-purchase plan which permits all full-time employees to purchase 10 shares of common stock on the third anniversary of their employment and an additional 15 shares on each subsequent anniversary date. The purchase price is set at the market price on the date purchased and no commission is charged. Discuss whether this plan would be considered compensatory.
12.
What date or event does the profession believe should be used in determining the value of a stock option? What arguments support this position?
13.
Over what period of time should compensation cost be allocated?
14.
How is compensation expense computed using the fair value approach?
15.
What are the advantages of using restricted stock to compensate employees? 16. At December 31, 2012, Reid Company had 600,000 shares of common stock issued and outstanding, 400,000 of which had been issued and outstanding throughout the year and 200,000 of which were issued on October 1, 2012. Net income for 2012 was $2,000,000, and dividends declared on preferred stock were $400,000. Compute Reid’s earnings per common share. (Round to the nearest penny.)
17.
What effect do stock dividends or stock splits have on the computation of the weighted-average number of shares outstanding?
18.
Define the following terms. (a) Basic earnings per share. (b) Potentially dilutive security. (c) Diluted earnings per share. (d) Complex capital structure. (e) Potential common stock.
19.
What are the computational guidelines for determining whether a convertible security is to be reported as part of diluted earnings per share?
20.
Discuss why options and warrants may be considered potentially dilutive common shares for the computation of diluted earnings per share.
21.
Explain how convertible securities are determined to be potentially dilutive common shares and how those convertible securities that are not considered to be potentially dilutive common shares enter into the determination of earnings per share data.
22.
Explain the treasury-stock method as it applies to options and warrants in computing dilutive earnings per share data.
23.
Earnings per share can affect market prices of common stock. Can market prices affect earnings per share? Explain.
24.
What is meant by the term antidilution? Give an example.
25.
What type of earnings per share presentation is required in a complex capital structure?
*
26. How is antidilution determined when multiple securities are involved? Bonds Payable 1,000,000 Discount on Bonds Payable 40,000 Common Stock 800,000 Paid-in Capital in Excess of Par— Common Stock 160,000 Discuss the propriety of this accounting treatment. BRI E F EXERCI S E S
BE16-1
Archer Inc. issued $4,000,000 par value, 7% convertible bonds at 99 for cash. If the bonds had not included the conversion feature, they would have sold for 95. Prepare the journal entry to record the issuance of the bonds.
BE16-2
Petrenko Corporation has outstanding 2,000 $1,000 bonds, each convertible into 50 shares of $10 par value common stock. The bonds are converted on December 31, 2012, when the unamortized discount is $30,000 and the market price of the stock is $21 per share. Record the conversion using the book value approach.
BE16-3
Pechstein Corporation issued 2,000 shares of $10 par value common stock upon conversion of 1,000 shares of $50 par value preferred stock. The preferred stock was originally issued at $60 per share. The common stock is trading at $26 per share at the time of conversion. Record the conversion of the preferred stock.
BE16-4
Eisler Corporation issued 2,000 $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market price of $40. Use the proportional method to record the issuance of the bonds and warrants.
BE16-5
McIntyre Corporation issued 2,000 $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling separately at 98. The market price of the warrants without the bonds cannot be determined. Use the incremental method to record the issuance of the bonds and warrants.
BE16-6
On January 1, 2012, Barwood Corporation granted 5,000 options to executives. Each option entitles the holder to purchase one share of Barwood’s $5 par value common stock at $50 per share at any time during the next 5 years. The market price of the stock is $65 per share on the date of grant. The fair value of the options at the grant date is $150,000. The period of benefit is 2 years. Prepare Barwood’s journal entries for January 1, 2012, and December 31, 2012 and 2013.
BE16-7
Refer to the data for Barwood Corporation in
BE16-6. Repeat the requirements assuming that instead of options, Barwood granted 2,000 shares of restricted stock.

BE16-8
On January 1, 2012 (the date of grant), Lutz Corporation issues 2,000 shares of restricted stock to its executives. The fair value of these shares is $75,000, and their par value is $10,000. The stock is forfeited if the executives do not complete 3 years of employment with the company. Prepare the journal entry (if any) on January 1, 2012, and on December 31, 2012, assuming the service period is 3 years.
BE16-9
Kalin Corporation had 2012 net income of $1,000,000. During 2012, Kalin paid a dividend of $2 per share on 100,000 shares of preferred stock. During 2012, Kalin had outstanding 250,000 shares of common stock. Compute Kalin’s 2012 earnings per share.
BE16-10
Douglas Corporation had 120,000 shares of stock outstanding on January 1, 2012. On May 1, 2012, Douglas issued 60,000 shares. On July 1, Douglas purchased 10,000 treasury shares, which were reissued on October 1. Compute Douglas’s weighted-average number of shares outstanding for 2012.
BE16-11
Tomba Corporation had 300,000 shares of common stock outstanding on January 1, 2012. On May 1, Tomba issued 30,000 shares. (a) Compute the weighted-average number of shares outstanding if the 30,000 shares were issued for cash. (b) Compute the weighted-average number of shares outstanding if the 30,000 shares were issued in a stock dividend.
BE16-12
Rockland Corporation earned net income of $300,000 in 2012 and had 100,000 shares of common stock outstanding throughout the year. Also outstanding all year was $800,000 of 10% bonds, which are convertible into 16,000 shares of common. Rockland’s tax rate is 40 percent. Compute Rockland’s 2012 diluted earnings per share.
BE16-13
DiCenta Corporation reported net income of $270,000 in 2012 and had 50,000 shares of common stock outstanding throughout the year. Also outstanding all year were 5,000 shares of cumulative preferred stock, each convertible into 2 shares of common. The preferred stock pays an annual dividend of $5 per share. DiCenta’s tax rate is 40%. Compute DiCenta’s 2012 diluted earnings per share.
BE16-14
Bedard Corporation reported net income of $300,000 in 2012 and had 200,000 shares of common stock outstanding throughout the year. Also outstanding all year were 45,000 options to purchase common stock at $10 per share. The average market price of the stock during the year was $15. Compute diluted earnings per share. 1 1 2 3 3 4 4 4 6 6 6 7 7 7
BE16-15
The 2012 income statement of Wasmeier Corporation showed net income of $480,000 and an extraordinary loss of $120,000. Wasmeier had 100,000 shares of common stock outstanding all year. Prepare Wasmeier’s income statement presentation of earnings per share. * B E16-16 Ferraro, Inc. established a stock-appreciation rights (SAR) program on January 1, 2012, which entitles executives to receive cash at the date of exercise for the difference between the market price of the stock and the pre-established price of $20 on 5,000 SARs. The required service period is 2 years. The fair value of the SARs are determined to be $4 on December 31, 2012, and $9 on December 31, 2013. Compute Ferraro’s compensation expense for 2012 and 2013. 6 8 EXERCI S E S
E16-1 (Issuance and Conversion of Bonds)
For each of the unrelated transactions described below, present the entry(ies) required to record each transaction. 1. Coyle Corp. issued $10,000,000 par value 10% convertible bonds at 99. If the bonds had not been convertible, the company’s investment banker estimates they would have been sold at 95. Expenses of issuing the bonds were $70,000. 2. Lambert Company issued $10,000,000 par value 10% bonds at 98. One detachable stock warrant was issued with each $100 par value bond. At the time of issuance, the warrants were selling for $4. 3. Sepracor, Inc. called its convertible debt in 2012. Assume the following related to the transaction: The 11%, $10,000,000 par value bonds were converted into 1,000,000 shares of $1 par value common stock on July 1, 2012. On July 1, there was $55,000 of unamortized discount applicable to the bonds, and the company paid an additional $75,000 to the bondholders to induce conversion of all the bonds. The company records the conversion using the book value method.
E16-2 (Conversion of Bonds)
Schuss Inc. issued $3,000,000 of 10%, 10-year convertible bonds on June 1, 2012, at 98 plus accrued interest. The bonds were dated April 1, 2012, with interest payable April 1 and October 1. Bond discount is amortized semiannually on a straight-line basis. On April 1, 2013, $1,000,000 of these bonds were converted into 30,000 shares of $20 par value common stock. Accrued interest was paid in cash at the time of conversion.
Instructions
(a) Prepare the entry to record the interest expense at October 1, 2012. Assume that accrued interest payable was credited when the bonds were issued. (Round to nearest dollar.) (b) Prepare the entry(ies) to record the conversion on April 1, 2013. (The book value method is used.) Assume that the entry to record amortization of the bond discount and interest payment has been made.
E16-3 (Conversion of Bonds)
Gabel Company has bonds payable outstanding in the amount of $400,000, and the Premium on Bonds Payable account has a balance of $6,000. Each $1,000 bond is convertible into 20 shares of preferred stock of par value of $50 per share. All bonds are converted into preferred stock.
Instructions
Assuming that the book value method was used, what entry would be made?
E16-4 (Conversion of Bonds)
On January 1, 2012, when its $30 par value common stock was selling for $80 per share, Bartz Corp. issued $10,000,000 of 8% convertible debentures due in 20 years. The conversion option allowed the holder of each $1,000 bond to convert the bond into five shares of the corporation’s common stock. The debentures were issued for $10,600,000. The present value of the bond payments at the time of issuance was $8,500,000, and the corporation believes the difference between the present value and the amount paid is attributable to the conversion feature. On January 1, 2013, the corporation’s $30 par value common stock was split 2 for 1, and the conversion rate for the bonds was adjusted accordingly. On January 1, 2014, when the corporation’s $15 par value common stock was selling for $135 per share, holders of 20% of the convertible debentures exercised their conversion options. The corporation uses the straight-line method for amortizing any bond discounts or premiums.
Instructions
(a) Prepare the entry to record the original issuance of the convertible debentures. (b) Prepare the entry to record the exercise of the conversion option, using the book value method. Show supporting computations in good form.
E16-5 (Conversion of Bonds)
The December 31, 2012, balance sheet of Osygus Corp. is as follows. 10% callable, convertible bonds payable (semiannual interest dates April 30 and October 31; convertible into 6 shares of $25 par value common stock per $1,000 of bond principal; maturity date April 30, 2018) $600,000 Discount on bonds payable 10,240 $589,760 On March 5, 2013, Osygus Corp. called all of the bonds as of April 30, for the principal plus interest through April 30. By April 30, all bondholders had exercised their conversion to common stock as of the interest payment date. Consequently, on April 30, Osygus Corp. paid the semiannual interest and issued shares of common stock for the bonds. The discount is amortized on a straight-line basis. Osygus uses the book value method.
Instructions
Prepare the entry(ies) to record the interest expense and conversion on April 30, 2013. Reversing entries were made on January 1, 2013.
E16-6 (Conversion of Bonds)
On January 1, 2011, Trillini Corporation issued $3,000,000 of 10-year, 8% convertible debentures at 102. Interest is to be paid semiannually on June 30 and December 31. Each $1,000 debenture can be converted into eight shares of Trillini Corporation $100 par value common stock after December 31, 2012. On January 1, 2013, $600,000 of debentures are converted into common stock, which is then selling at $110. An additional $600,000 of debentures are converted on March 31, 2013. The market price of the common stock is then $115. Accrued interest at March 31 will be paid on the next interest date. Bond premium is amortized on a straight-line basis.
Instructions
Make the necessary journal entries for: (a) December 31, 2012. (c) March 31, 2013. (b) January 1, 2013. (d) June 30, 2013. Record the conversions using the book value method.
E16-7 (Issuance of Bonds with Warrants)
Prior Inc. has decided to raise additional capital by issuing $175,000 face value of bonds with a coupon rate of 10%. In discussions with investment bankers, it was determined that to help the sale of the bonds, detachable stock warrants should be issued at the rate of one warrant for each $100 bond sold. The value of the bonds without the warrants is considered to be $136,000, and the value of the warrants in the market is $24,000. The bonds sold in the market at issuance for $150,000.
Instructions
(a) What entry should be made at the time of the issuance of the bonds and warrants? (b) If the warrants were nondetachable, would the entries be different? Discuss.
E16-8 (Issuance of Bonds with Detachable Warrants)
On September 1, 2012, Jacob Company sold at 104 (plus accrued interest) 3,000 of its 8%, 10-year, $1,000 face value, nonconvertible bonds with detachable stock warrants. Each bond carried two detachable warrants. Each warrant was for one share of common stock at a specified option price of $15 per share. Shortly after issuance, the warrants were quoted on the market for $3 each. No fair value can be determined for the Jacob Company bonds. Interest is payable on December 1 and June 1. Bond issue costs of $30,000 were incurred.
Instructions
Prepare in general journal format the entry to record the issuance of the bonds. (AICPA adapted)
E16-9 (Issuance of Bonds with Stock Warrants)
On May 1, 2012, Barkley Company issued 3,000 $1,000 bonds at 102. Each bond was issued with one detachable stock warrant. Shortly after issuance, the bonds were selling at 98, but the fair value of the warrants cannot be determined. 1 1 3 3 3
Instructions
(a) Prepare the entry to record the issuance of the bonds and warrants. (b) Assume the same facts as part (a), except that the warrants had a fair value of $20. Prepare the entry to record the issuance of the bonds and warrants.
E16-10 (Issuance and Exercise of Stock Options)
On November 1, 2011, Olympic Company adopted a stock-option plan that granted options to key executives to purchase 40,000 shares of the company’s $10 par value common stock. The options were granted on January 2, 2012, and were exercisable 2 years after the date of grant if the grantee was still an employee of the company. The options expired 6 years from date of grant. The option price was set at $40, and the fair value option-pricing model determines the total compensation expense to be $600,000. All of the options were exercised during the year 2014: 30,000 on January 3 when the market price was $67, and 10,000 on May 1 when the market price was $77 a share.
Instructions
Prepare journal entries relating to the stock-option plan for the years 2012, 2013, and 2014. Assume that the employee performs services equally in 2012 and 2013.
E16-11 (Issuance, Exercise, and Termination of Stock Options)
On January 1, 2012, Magilla Inc. granted stock options to officers and key employees for the purchase of 20,000 shares of the company’s $10 par common stock at $25 per share. The options were exercisable within a 5-year period beginning January 1, 2014, by grantees still in the employ of the company, and expiring December 31, 2016. The service period for this award is 2 years. Assume that the fair value option-pricing model determines total compensation expense to be $400,000. On April 1, 2013, 3,000 options were terminated when the employees resigned from the company. The market price of the common stock was $35 per share on this date. On March 31, 2014, 12,000 options were exercised when the market price of the common stock was $40 per share.
Instructions
Prepare journal entries to record issuance of the stock options, termination of the stock options, exercise of the stock options, and charges to compensation expense, for the years ended December 31, 2012, 2013, and 2014.
E16-12 (Issuance, Exercise, and Termination of Stock Options)
On January 1, 2011, Scooby Corporation granted 10,000 options to key executives. Each option allows the executive to purchase one share of Scooby’s $5 par value common stock at a price of $20 per share. The options were exercisable within a 2-year period beginning January 1, 2013, if the grantee is still employed by the company at the time of the exercise. On the grant date, Scooby’s stock was trading at $25 per share, and a fair value option-pricing model determines total compensation to be $450,000. On May 1, 2013, 9,000 options were exercised when the market price of Scooby’s stock was $30 per share. The remaining options lapsed in 2015 because executives decided not to exercise their options.
Instructions
Prepare the necessary journal entries related to the stock-option plan for the years 2011 through 2015.
E16-13 (Accounting for Restricted Stock)
Derrick Company issues 4,000 shares of restricted stock to its CFO, Dane Yaping, on January 1, 2012. The stock has a fair value of $120,000 on this date. The service period related to this restricted stock is 4 years. Vesting occurs if Yaping stays with the company for 4 years. The par value of the stock is $5. At December 31, 2013, the fair value of the stock is $145,000.
Instructions
(a) Prepare the journal entries to record the restricted stock on January 1, 2012 (the date of grant), and December 31, 2013. (b) On March 4, 2014, Yaping leaves the company. Prepare the journal entry (if any) to account for this forfeiture.
E16-14 (Accounting for Restricted Stock)
Tweedie Company issues 10,000 shares of restricted stock to its CFO, Mary Tokar, on January 1, 2012. The stock has a fair value of $500,000 on this date. The service period related to this restricted stock is 5 years. Vesting occurs if Tokar stays with the company until December 31, 2016. The par value of the stock is $10. At December 31, 2012, the fair value of the stock is $450,000.
Instructions
(a) Prepare the journal entries to record the restricted stock on January 1, 2012 (the date of grant), and December 31, 2013. (b) On July 25, 2016, Tokar leaves the company. Prepare the journal entry (if any) to account for this forfeiture.
E16-15 (Weighted-Average Number of Shares)
Gogean Inc. uses a calendar year for financial reporting. The company is authorized to issue 9,000,000 shares of $10 par common stock. At no time has Gogean issued any potentially dilutive securities. Listed below is a summary of Gogean’s common stock activities. February 1 Issued 120,000 shares March 1 Issued a 20% stock dividend May 1 Acquired 100,000 shares of treasury stock June 1 Issued a 3-for-1 stock split October 1 Reissued 60,000 shares of treasury stock
Instructions
(a) Compute the weighted-average number of common shares used in computing earnings per common share for 2012 on the 2013 comparative income statement. (b) Compute the weighted-average number of common shares used in computing earnings per common share for 2013 on the 2013 comparative income statement. (c) Compute the weighted-average number of common shares to be used in computing earnings per common share for 2013 on the 2014 comparative income statement. (d) Compute the weighted-average number of common shares to be used in computing earnings per common share for 2014 on the 2014 comparative income statement. (CMA adapted)
E16-16 (EPS: Simple Capital Structure)
On January 1, 2012, Chang Corp. had 480,000 shares of common stock outstanding. During 2012, it had the following transactions that affected the Common Stock account.
Instructions
Compute earnings per share.
Instructions
(a) Determine the weighted-average number of shares outstanding as of December 31, 2012. (b) Assume that Chang Corp. earned net income of $3,256,000 during 2012. In addition, it had 100,000 shares of 9%, $100 par nonconvertible, noncumulative preferred stock outstanding for the entire year. Because of liquidity considerations, however, the company did not declare and pay a preferred dividend in 2012. Compute earnings per share for 2012, using the weighted-average number of shares determined in part (a). (c) Assume the same facts as in part (b), except that the preferred stock was cumulative. Compute earnings per share for 2012. (d) Assume the same facts as in part (b), except that net income included an extraordinary gain of $864,000 and a loss from discontinued operations of $432,000. Both items are net of applicable income taxes. Compute earnings per share for 2012.
E16-17 (EPS: Simple Capital Structure)
Ott Company had 210,000 shares of common stock outstanding on December 31, 2012. During the year 2013, the company issued 8,000 shares on May 1 and retired 14,000 shares on October 31. For the year 2013, Ott Company reported net income of $229,690 after a casualty loss of $40,600 (net of tax).
Instructions
What earnings per share data should be reported at the bottom of its income statement, assuming that the casualty loss is extraordinary?
E16-18 (EPS: Simple Capital Structure)
Kendall Inc. presented the following data. Net income $2,200,000 Preferred stock: 50,000 shares outstanding, $100 par, 8% cumulative, not convertible 5,000,000 Common stock: Shares outstanding 1/1 600,000 Issued for cash, 5/1 300,000 Acquired treasury stock for cash, 8/1 150,000 2-for-1 stock split, 10/1 1. Number of common shares issued and outstanding at December 31, 2011 2,400,000 2. Shares issued as a result of a 10% stock dividend on September 30, 2012 240,000 3. Shares issued for cash on March 31, 2013 2,000,000 Number of common shares issued and outstanding at December 31, 2013 4,640,000 4. A 2-for-1 stock split of Gogean’s common stock took place on March 31, 2014 6 6 6 6
E16-19 (EPS: Simple Capital Structure)
A portion of the statement of income and retained earnings of Pierson Inc. for the current year follows. At the end of the current year, Pierson Inc. has outstanding 8,000,000 shares of $10 par common stock and 50,000 shares of 6% preferred. On April 1 of the current year, Pierson Inc. issued 1,000,000 shares of common stock for $32 per share to help finance the casualty.
Instructions
Compute the earnings per share on common stock for the current year as it should be reported to stockholders.
E16-20 (EPS: Simple Capital Structure)
On January 1, 2012, Bailey Industries had stock outstanding as follows. 6% Cumulative preferred stock, $100 par value, issued and outstanding 10,000 shares $1,000,000 Common stock, $10 par value, issued and outstanding 200,000 shares 2,000,000 On May 14, 2012, Bailey realized a $90,000 (before taxes) insurance gain on the expropriation of investments originally purchased in 2000. On December 31, 2012, Bailey recorded net income of $300,000 before tax and exclusive of the gain.
Instructions
Assuming a 40% tax rate, compute the earnings per share data that should appear on the financial statements of Bailey Industries as of December 31, 2012. Assume that the expropriation is extraordinary.
E16-21 (EPS: Simple Capital Structure)
At January 1, 2012, Cameron Company’s outstanding shares included the following. 280,000 shares of $50 par value, 7% cumulative preferred stock 800,000 shares of $1 par value common stock Net income for 2012 was $2,830,000. No cash dividends were declared or paid during 2012. On February 15, 2013, however, all preferred dividends in arrears were paid, together with a 5% stock dividend on common shares. There were no dividends in arrears prior to 2012. On April 1, 2012, 450,000 shares of common stock were sold for $10 per share, and on October 1, 2012, 110,000 shares of common stock were purchased for $20 per share and held as treasury stock.
Instructions
Compute earnings per share for 2012. Assume that financial statements for 2012 were issued in March 2013. To acquire the net assets of three smaller companies, Bailey authorized the issuance of an additional 170,000 common shares. The acquisitions took place as shown below. Income before extraordinary item $15,000,000 Extraordinary loss, net of applicable income tax (Note 1) 1,340,000 Net income 13,660,000 Retained earnings at the beginning of the year 83,250,000 96,910,000 Dividends declared: On preferred stock—$6.00 per share $ 300,000 On common stock—$1.75 per share 14,000,000 14,300,000 Retained earnings at the end of the year $82,610,000 Note 1. During the year, Pierson Inc. suffered a major casualty loss of $1,340,000 after applicable income tax reduction of $1,200,000. Date of Acquisition Shares Issued Company A April 1, 2012 60,000 Company B July 1, 2012 80,000 Company C October 1, 2012 30,000
E16-22 (EPS with Convertible Bonds, Various Situations)
In 2012, Buraka Enterprises issued, at par, 75 $1,000, 8% bonds, each convertible into 100 shares of common stock. Buraka had revenues of $17,500 and expenses other than interest and taxes of $8,400 for 2013. (Assume that the tax rate is 40%.) Throughout 2013, 2,000 shares of common stock were outstanding; none of the bonds was converted or redeemed.
Instructions
(a) Compute diluted earnings per share for 2013. (b) Assume the same facts as those assumed for part (a), except that the 75 bonds were issued on September 1, 2013 (rather than in 2012), and none have been converted or redeemed. (c) Assume the same facts as assumed for part (a), except that 25 of the 75 bonds were actually converted on July 1, 2013.
E16-23 (EPS with Convertible Bonds)
On June 1, 2011, Bluhm Company and Amanar Company merged to form Davenport Inc. A total of 800,000 shares were issued to complete the merger. The new corporation reports on a calendar-year basis. On April 1, 2013, the company issued an additional 600,000 shares of stock for cash. All 1,400,000 shares were outstanding on December 31, 2013. Davenport Inc. also issued $600,000 of 20-year, 8% convertible bonds at par on July 1, 2013. Each $1,000 bond converts to 40 shares of common at any interest date. None of the bonds have been converted to date. Davenport Inc. is preparing its annual report for the fiscal year ending December 31, 2013. The annual report will show earnings per share figures based upon a reported after-tax net income of $1,540,000. (The tax rate is 40%.)
Instructions
Determine the following for 2013. (a) The number of shares to be used for calculating: (1) Basic earnings per share. (2) Diluted earnings per share. (b) The earnings figures to be used for calculating: (1) Basic earnings per share. (2) Diluted earnings per share. (CMA adapted)
E16-24 (EPS with Convertible Bonds and Preferred Stock)
The Ottey Corporation issued 10-year, $4,000,000 par, 7% callable convertible subordinated debentures on January 2, 2012. The bonds have a par value of $1,000, with interest payable annually. The current conversion ratio is 14:1, and in 2 years it will increase to 18:1. At the date of issue, the bonds were sold at 98. Bond discount is amortized on a straightline basis. Ottey’s effective tax was 35%. Net income in 2012 was $7,500,000, and the company had 2,000,000 shares outstanding during the entire year.
Instructions
(a) Prepare a schedule to compute both basic and diluted earnings per share. (b) Discuss how the schedule would differ if the security was convertible preferred stock.
E16-25 (EPS with Convertible Bonds and Preferred Stock)
On January 1, 2012, Lindsey Company issued 10-year, $3,000,000 face value, 6% bonds, at par. Each $1,000 bond is convertible into 15 shares of Lindsey common stock. Lindsey’s net income in 2013 was $240,000, and its tax rate was 40%. The company had 100,000 shares of common stock outstanding throughout 2012. None of the bonds were converted in 2012.
Instructions
(a) Compute diluted earnings per share for 2012. (b) Compute diluted earnings per share for 2012, assuming the same facts as above, except that $1,000,000 of 6% convertible preferred stock was issued instead of the bonds. Each $100 preferred share is convertible into 5 shares of Lindsey common stock.
E16-26 (EPS with Options, Various Situations)
Zambrano Company’s net income for 2012 is $40,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2011, each exercisable for 7 7 7 2 7 2 7 one share at $8. None has been exercised, and 10,000 shares of common were outstanding during 2012. The average market price of Zambrano’s stock during 2012 was $20.
Instructions
(a) Compute diluted earnings per share. (Round to the nearest cent.) (b) Assume the same facts as those assumed for part (a), except that the 1,000 options were issued on October 1, 2012 (rather than in 2011). The average market price during the last 3 months of 2012 was $20.
E16-27 (EPS with Contingent Issuance Agreement)
Brooks Inc. recently purchased Donovan Corp., a large midwestern home painting corporation. One of the terms of the merger was that if Donovan’s income for 2013 was $110,000 or more, 10,000 additional shares would be issued to Donovan’s stockholders in 2014. Donovan’s income for 2012 was $125,000.
Instructions
(a) Would the contingent shares have to be considered in Brooks’s 2012 earnings per share computations? (b) Assume the same facts, except that the 10,000 shares are contingent on Donovan’s achieving a net income of $130,000 in 2013. Would the contingent shares have to be considered in Brooks’s earnings per share computations for 2012?
E16-28 (EPS with Warrants)
Werth Corporation earned $260,000 during a period when it had an average of 100,000 shares of common stock outstanding. The common stock sold at an average market price of $15 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock for $10 for each warrant exercised.
Instructions
(a) Are the warrants dilutive? (b) Compute basic earnings per share. (c) Compute diluted earnings per share. *E 16-29 (Stock-Appreciation Rights) On December 31, 2009, Flessel Company issues 120,000 stockappreciation rights to its officers entitling them to receive cash for the difference between the market price of its stock and a pre-established price of $10. The fair value of the SARs is estimated to be $4 per SAR on December 31, 2010; $1 on December 31, 2011; $11 on December 31, 2012; and $9 on December 31, 2013. The service period is 4 years, and the exercise period is 7 years.
Instructions
(a) Prepare a schedule that shows the amount of compensation expense allocable to each year affected by the stock-appreciation rights plan. (b) Prepare the entry at December 31, 2013, to record compensation expense, if any, in 2013. (c) Prepare the entry on December 31, 2013, assuming that all 120,000 SARs are exercised. *E 16-30 (Stock-Appreciation Rights) Derrick Company establishes a stock-appreciation rights program that entitles its new president, Dan Scott, to receive cash for the difference between the market price of the stock and a pre-established price of $30 (also market price) on January 1, 2011, on 40,000 SARs. The date of grant is January 1, 2011, and the required employment (service) period is 4 years. President Scott exercises all of the SARs in 2016. The fair value of the SARs is estimated to be $6 per SAR on December 31, 2011; $9 on December 31, 2012; $15 on December 31, 2013; $8 on December 31, 2014; and $18 on December 31, 2015.
Instructions
(a) Prepare a 5-year (2011–2015) schedule of compensation expense pertaining to the 40,000 SARs granted to president Scott. (b) Prepare the journal entry for compensation expense in 2011, 2014, and 2015 relative to the 40,000 SARs. PROBLEMS
P16-1 (Entries for Various Dilutive Securities)
The stockholders’ equity section of Martino Inc. at the beginning of the current year appears below. Common stock, $10 par value, authorized 1,000,000 shares, 300,000 shares issued and outstanding $3,000,000 Paid-in capital in excess of par—common stock 600,000 Retained earnings 570,000 During the current year, the following transactions occurred. 1. The company issued to the stockholders 100,000 rights. Ten rights are needed to buy one share of stock at $32. The rights were void after 30 days. The market price of the stock at this time was $34 per share. 2. The company sold to the public a $200,000, 10% bond issue at 104. The company also issued with each $100 bond one detachable stock purchase warrant, which provided for the purchase of common stock at $30 per share. Shortly after issuance, similar bonds without warrants were selling at 96 and the warrants at $8. 3. All but 5,000 of the rights issued in (1) were exercised in 30 days. 4. At the end of the year, 80% of the warrants in (2) had been exercised, and the remaining were outstanding and in good standing. 5. During the current year, the company granted stock options for 10,000 shares of common stock to company executives. The company, using a fair value option-pricing model, determines that each option is worth $10. The option price is $30. The options were to expire at year-end and were considered compensation for the current year. 6. All but 1,000 shares related to the stock-option plan were exercised by year-end. The expiration resulted because one of the executives failed to fulfill an obligation related to the employment contract.
Instructions
(a) Prepare general journal entries for the current year to record the transactions listed above. (b) Prepare the stockholders’ equity section of the balance sheet at the end of the current year. Assume that retained earnings at the end of the current year is $750,000.
P16-2 (Entries for Conversion, Amortization, and Interest of Bonds)
Volker Inc. issued $2,500,000 of convertible 10-year bonds on July 1, 2012. The bonds provide for 12% interest payable semiannually on January 1 and July 1. The discount in connection with the issue was $54,000, which is being amortized monthly on a straight-line basis. The bonds are convertible after one year into 8 shares of Volker Inc.’s $100 par value common stock for each $1,000 of bonds. On August 1, 2013, $250,000 of bonds were turned in for conversion into common stock. Interest has been accrued monthly and paid as due. At the time of conversion, any accrued interest on bonds being converted is paid in cash.
Instructions
Prepare the journal entries to record the conversion, amortization, and interest in connection with the bonds as of the following dates. (Round to the nearest dollar.) (a) August 1, 2013. (Assume the book value method is used.) (b) August 31, 2013. (c) December 31, 2013, including closing entries for end-of-year. (AICPA adapted)
P16-3 (Stock-Option Plan)
Berg Company adopted a stock-option plan on November 30, 2011, that provided that 70,000 shares of $5 par value stock be designated as available for the granting of options to officers of the corporation at a price of $9 a share. The market price was $12 a share on November 30, 2012. On January 2, 2012, options to purchase 28,000 shares were granted to president Tom Winter—15,000 for services to be rendered in 2012 and 13,000 for services to be rendered in 2013. Also on that date, options to purchase 14,000 shares were granted to vice president Michelle Bennett—7,000 for services to be rendered in 2012 and 7,000 for services to be rendered in 2013. The market price of the stock was $14 a share on January 2, 2012. The options were exercisable for a period of one year following the year in which the services were rendered. The fair value of the options on the grant date was $4 per option. 1 3 4 1 4 In 2013, neither the president nor the vice president exercised their options because the market price of the stock was below the exercise price. The market price of the stock was $8 a share on December 31, 2013, when the options for 2012 services lapsed. On December 31, 2014, both president Winter and vice president Bennett exercised their options for 13,000 and 7,000 shares, respectively, when the market price was $16 a share.
Instructions
Prepare the necessary journal entries in 2011 when the stock-option plan was adopted, in 2012 when options were granted, in 2013 when options lapsed, and in 2014 when options were exercised.
P16-4 (Stock-Based Compensation)
Assume that Amazon has a stock-option plan for top management. Each stock option represents the right to purchase a share of Amazon $1 par value common stock in the future at a price equal to the fair value of the stock at the date of the grant. Amazon has 5,000 stock options outstanding, which were granted at the beginning of 2012. The following data relate to the option grant. Exercise price for options $40 Market price at grant date (January 1, 2012) $40 Fair value of options at grant date (January 1, 2012) $6 Service period 5 years
Instructions
(a) Prepare the journal entry(ies) for the first year of the stock-option plan. (b) Prepare the journal entry(ies) for the first year of the plan assuming that, rather than options, 700 shares of restricted stock were granted at the beginning of 2012. (c) Now assume that the market price of Amazon stock on the grant date was $45 per share. Repeat the requirements for (a) and (b). (d) Amazon would like to implement an employee stock-purchase plan for rank-and-file employees, but it would like to avoid recording expense related to this plan. Which of the following provisions must be in place for the plan to avoid recording compensation expense? (1) Substantially all employees may participate. (2) The discount from market is small (less than 5%). (3) The plan offers no substantive option feature. (4) There is no preferred stock outstanding.
P16-5 (EPS with Complex Capital Structure)
Amy Dyken, controller at Fitzgerald Pharmaceutical Industries, a public company, is currently preparing the calculation for basic and diluted earnings per share and the related disclosure for Fitzgerald’s financial statements. Below is selected financial information for the fiscal year ended June 30, 2012. FITZGERALD PHARMACEUTICAL INDUSTRIES SELECTED BALANCE SHEET INFORMATION JUNE 30, 2012 Long-term debt Notes payable, 10% $ 1,000,000 8% convertible bonds payable 5,000,000 10% bonds payable 6,000,000 Total long-term debt $12,000,000 Shareholders’ equity Preferred stock, 6% cumulative, $50 par value, 100,000 shares authorized, 25,000 shares issued and outstanding $ 1,250,000 Common stock, $1 par, 10,000,000 shares authorized, 1,000,000 shares issued and outstanding 1,000,000 Additional paid-in capital 4,000,000 Retained earnings 6,000,000 Total shareholders’ equity $12,250,000 4 The following transactions have also occurred at Fitzgerald. 1. Options were granted on July 1, 2011, to purchase 200,000 shares at $15 per share. Although no options were exercised during fiscal year 2012, the average price per common share during fiscal year 2012 was $20 per share. 2. Each bond was issued at face value. The 8% convertible bonds will convert into common stock at 50 shares per $1,000 bond. The bonds are exercisable after 5 years and were issued in fiscal year 2011. 3. The preferred stock was issued in 2011. 4. There are no preferred dividends in arrears; however, preferred dividends were not declared in fiscal year 2012. 5. The 1,000,000 shares of common stock were outstanding for the entire 2012 fiscal year. 6. Net income for fiscal year 2012 was $1,500,000, and the average income tax rate is 40%.
Instructions
For the fiscal year ended June 30, 2012, calculate the following for Fitzgerald Pharmaceutical Industries. (a) Basic earnings per share. (b) Diluted earnings per share.
P16-6 (Basic EPS: Two-Year Presentation)
Melton Corporation is preparing the comparative financial statements for the annual report to its shareholders for fiscal years ended May 31, 2012, and May 31, 2013. The income from operations for each year was $1,800,000 and $2,500,000, respectively. In both years, the company incurred a 10% interest expense on $2,400,000 of debt, an obligation that requires interest-only payments for 5 years. The company experienced a loss of $600,000 from a fire in its Scotsland facility in February 2013, which was determined to be an extraordinary loss. The company uses a 40% effective tax rate for income taxes. The capital structure of Melton Corporation on June 1, 2011, consisted of 1 million shares of common stock outstanding and 20,000 shares of $50 par value, 6%, cumulative preferred stock. There were no preferred dividends in arrears, and the company had not issued any convertible securities, options, or warrants. On October 1, 2011, Melton sold an additional 500,000 shares of the common stock at $20 per share. Melton distributed a 20% stock dividend on the common shares outstanding on January 1, 2012. On December 1, 2012, Melton was able to sell an additional 800,000 shares of the common stock at $22 per share. These were the only common stock transactions that occurred during the two fiscal years.
Instructions
(a) Identify whether the capital structure at Melton Corporation is a simple or complex capital structure, and explain why. (b) Determine the weighted-average number of shares that Melton Corporation would use in calculating earnings per share for the fiscal year ended: (1) May 31, 2012. (2) May 31, 2013. (c) Prepare, in good form, a comparative income statement, beginning with income from operations, for Melton Corporation for the fiscal years ended May 31, 2012, and May 31, 2013. This statement will be included in Melton’s annual report and should display the appropriate earnings per share presentations. (CMA adapted)
P16-7 (Computation of Basic and Diluted EPS)
Charles Austin of the controller’s office of Thompson Corporation was given the assignment of determining the basic and diluted earnings per share values for the year ending December 31, 2013. Austin has compiled the information listed below. 1. The company is authorized to issue 8,000,000 shares of $10 par value common stock. As of December 31, 2012, 2,000,000 shares had been issued and were outstanding. 2. The per share market prices of the common stock on selected dates were as follows. Price per Share July 1, 2012 $20.00 January 1, 2013 21.00 April 1, 2013 25.00 July 1, 2013 11.00 August 1, 2013 10.50 November 1, 2013 9.00 December 31, 2013 10.00 6 7 3. A total of 700,000 shares of an authorized 1,200,000 shares of convertible preferred stock had been issued on July 1, 2012. The stock was issued at its par value of $25, and it has a cumulative dividend of $3 per share. The stock is convertible into common stock at the rate of one share of convertible preferred for one share of common. The rate of conversion is to be automatically adjusted for stock splits and stock dividends. Dividends are paid quarterly on September 30, December 31, March 31, and June 30. 4. Thompson Corporation is subject to a 40% income tax rate. 5. The after-tax net income for the year ended December 31, 2013, was $11,550,000. The following specific activities took place during 2013. 1. January 1—A 5% common stock dividend was issued. The dividend had been declared on December 1, 2012, to all stockholders of record on December 29, 2012. 2. April 1—A total of 400,000 shares of the $3 convertible preferred stock was converted into common stock. The company issued new common stock and retired the preferred stock. This was the only conversion of the preferred stock during 2013. 3. July 1—A 2-for-1 split of the common stock became effective on this date. The board of directors had authorized the split on June 1. 4. August 1—A total of 300,000 shares of common stock were issued to acquire a factory building. 5. November 1—A total of 24,000 shares of common stock were purchased on the open market at $9 per share. These shares were to be held as treasury stock and were still in the treasury as of December 31, 2013. 6. Common stock cash dividends—Cash dividends to common stockholders were declared and paid as follows. April 15—$0.30 per share October 15—$0.20 per share 7. Preferred stock cash dividends—Cash dividends to preferred stockholders were declared and paid as scheduled.
Instructions
(a) Determine the number of shares used to compute basic earnings per share for the year ended December 31, 2013. (b) Determine the number of shares used to compute diluted earnings per share for the year ended December 31, 2013. (c) Compute the adjusted net income to be used as the numerator in the basic earnings per share calculation for the year ended December 31, 2013.
P16-8 (Computation of Basic and Diluted EPS)
The information below pertains to Barkley Company for 2013. Net income for the year $1,200,000 8% convertible bonds issued at par ($1,000 per bond); each bond is convertible into 30 shares of common stock 2,000,000 6% convertible, cumulative preferred stock, $100 par value; each share is convertible into 3 shares of common stock 4,000,000 Common stock, $10 par value 6,000,000 Tax rate for 2013 40% Average market price of common stock $25 per share There were no changes during 2013 in the number of common shares, preferred shares, or convertible bonds outstanding. There is no treasury stock. The company also has common stock options (granted in a prior year) to purchase 75,000 shares of common stock at $20 per share.
Instructions
(a) Compute basic earnings per share for 2013. (b) Compute diluted earnings per share for 2013.
P16-9 (EPS with Stock Dividend and Extraordinary Items)
Agassi Corporation is preparing the comparative financial statements to be included in the annual report to stockholders. Agassi employs a fiscal year ending May 31. Income from operations before income taxes for Agassi was $1,400,000 and $660,000, respectively, for fiscal years ended May 31, 2013 and 2012. Agassi experienced an extraordinary loss of $400,000 because of an earthquake on March 3, 2013. A 40% combined income tax rate pertains to any and all of Agassi Corporation’s profits, gains, and losses. Agassi’s capital structure consists of preferred stock and common stock. The company has not issued any convertible securities or warrants and there are no outstanding stock options. 7 Agassi issued 40,000 shares of $100 par value, 6% cumulative preferred stock in 2009. All of this stock is outstanding, and no preferred dividends are in arrears. There were 1,000,000 shares of $1 par common stock outstanding on June 1, 2011. On September 1, 2011, Agassi sold an additional 400,000 shares of the common stock at $17 per share. Agassi distributed a 20% stock dividend on the common shares outstanding on December 1, 2012. These were the only common stock transactions during the past 2 fiscal years.
Instructions
(a) Determine the weighted-average number of common shares that would be used in computing earnings per share on the current comparative income statement for: (1) The year ended May 31, 2012. (2) The year ended May 31, 2013. (b) Starting with income from operations before income taxes, prepare a comparative income statement for the years ended May 31, 2013 and 2012. The statement will be part of Agassi Corporation’s annual report to stockholders and should include appropriate earnings per share presentation. (c) The capital structure of a corporation is the result of its past financing decisions. Furthermore, the earnings per share data presented on a corporation’s financial statements is dependent upon the capital structure. (1) Explain why Agassi Corporation is considered to have a simple capital structure. (2) Describe how earnings per share data would be presented for a corporation that has a complex capital structure. (CMA adapted) CONCEPTS FOR ANALYS I S
CA16-1 (Warrants Issued with Bonds and Convertible Bonds)
Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.
Instructions
(a) (1) Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock. (2) Discuss the underlying rationale for the differences described in (a)(1) above. (3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants. (b) At the start of the year, Huish Company issued $18,000,000 of 12% bonds along with warrants to buy 1,200,000 shares of its $10 par value common stock at $18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of $1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding, and the market price was $23 per share. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have been issued at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received. (AICPA adapted)
CA16-2 (Ethical Issues—Compensation Plan)
The executive officers of Rouse Corporation have a performance-based compensation plan. The performance criteria of this plan is linked to growth in earnings per share. When annual EPS growth is 12%, the Rouse executives earn 100% of the shares; if growth is 16%, they earn 125%. If EPS growth is lower than 8%, the executives receive no additional compensation. In 2012, Gail Devers, the controller of Rouse, reviews year-end estimates of bad debt expense and warranty expense. She calculates the EPS growth at 15%. Kurt Adkins, a member of the executive group, remarks over lunch one day that the estimate of bad debt expense might be decreased, increasing EPS growth to 16.1%. Devers is not sure she should do this because she believes that the current estimate of bad debts is sound. On the other hand, she recognizes that a great deal of subjectivity is involved in the computation.
Instructions
Answer the following questions. (a) What, if any, is the ethical dilemma for Devers? (b) Should Devers’s knowledge of the compensation plan be a factor that influences her estimate? (c) How should Devers respond to Adkins’s request?
CA16-3 (Stock Warrants—Various Types)
For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued: 1. To existing stockholders on a pro rata basis. 2. To certain key employees under an incentive stock-option plan. 3. To purchasers of the corporation’s bonds.
Instructions
For each of the three examples of how stock warrants are used: (a) Explain why they are used. (b) Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company’s stock, and (2) the length of time over which they can be exercised. (c) Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above. (AICPA adapted)
CA16-4 (Stock Compensation Plans)
The following two items appeared on the Internet concerning the GAAP requirement to expense stock options. WASHINGTON, D.C.February 17, 2005 Congressman David Dreier (R–CA), Chairman of the House Rules Committee, and Congresswoman Anna Eshoo (D–CA) reintroduced legislation today that will preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares. “Last year, the U.S. House of Representatives overwhelmingly voted for legislation that would have ensured the continued ability of innovative companies to offer stock options to rank-and-file employees,” Dreier stated. “Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) continue to ignore our calls to address legitimate concerns about the impact of FASB’s new standard on workers’ ability to have an ownership stake in the New Economy, and its failure to address the real need of shareholders: accurate and meaningful information about a company’s use of stock options.” “In December 2004, FASB issued a stock option expensing standard that will render a huge blow to the 21st century economy,” Dreier said. “Their action and the SEC’s apparent lack of concern for protecting shareholders, requires us to once again take a firm stand on the side of investors and economic growth. Giving investors the ability to understand how stock options impact the value of their shares is critical. And equally important is preserving the ability of companies to use this innovative tool to attract talented employees.” “Here We Go Again!” by Jack Ciesielski (2/21/2005, http://www.accountingobserver.com/blog/2005/02/herewe- go-again) On February 17, Congressman David Dreier (R–CA), and Congresswoman Anna Eshoo (D–CA), officially entered Silicon Valley’s bid to gum up the launch of honest reporting of stock option compensation: They co-sponsored a bill to “preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.” You know what “critical information” they mean: stuff like the stock compensation for the top five officers in a company, with a rigged value set as close to zero as possible. Investors crave this kind of information. Other ways the good Congresspersons want to “help” investors: The bill “also requires the SEC to study the effectiveness of those disclosures over three years, during which time, no new accounting standard related to the treatment of stock options could be recognized. Finally, the bill requires the Secretary of Commerce to conduct a study and report to Congress on the impact of broad-based employee stock option plans on expanding employee corporate ownership, skilled worker recruitment and retention, research and innovation, economic growth, and international competitiveness.” It’s the old “four corners” basketball strategy: stall, stall, stall. In the meantime, hope for regime change at your opponent, the FASB.
Instructions
(a) What are the major recommendations of the stock-based compensation pronouncement? (b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.) (c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.
CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt)
“Earnings per share” (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a “times earnings” figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.
Instructions
(a) Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS. (b) One of the technical procedures applicable in EPS computations is the “treasury-stock method.” Briefly describe the circumstances under which it might be appropriate to apply the treasury-stock method. (c) Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations. (AICPA adapted)
CA16-6 (EPS Concepts and Effect of Transactions on EPS)
Chorkina Corporation, a new audit client of yours, has not reported earnings per share data in its annual reports to stockholders in the past. The treasurer, Beth Botsford, requested that you furnish information about the reporting of earnings per share data in the current year’s annual report in accordance with generally accepted accounting principles.
Instructions
(a) Define the term “earnings per share” as it applies to a corporation with a capitalization structure composed of only one class of common stock. Explain how earnings per share should be computed and how the information should be disclosed in the corporation’s financial statements. (b) Discuss the treatment, if any, that should be given to each of the following items in computing earnings per share of common stock for financial statement reporting. (1) Outstanding preferred stock issued at a premium with a par value liquidation right. (2) The exercise at below market price but above book value of a common stock option issued during the current fiscal year to officers of the corporation. (3) The replacement of a machine immediately prior to the close of the current fiscal year at a cost 20% above the original cost of the replaced machine. The new machine will perform the same function as the old machine that was sold for its book value. (4) The declaration of current dividends on cumulative preferred stock. (5) The acquisition of some of the corporation’s outstanding common stock during the current fiscal year. The stock was classified as treasury stock. (6) A 2-for-1 stock split of common stock during the current fiscal year. (7) A provision created out of retained earnings for a contingent liability from a possible lawsuit.
CA16-7 (EPS, Antidilution)
Brad Dolan, a stockholder of Rhode Corporation, has asked you, the firm’s accountant, to explain why his stock warrants were not included in diluted EPS. In order to explain this situation, you must briefly explain what dilutive securities are, why they are included in the EPS calculation, and why some securities are antidilutive and thus not included in this calculation. Rhode Corporation earned $228,000 during the period, when it had an average of 100,000 shares of common stock outstanding. The common stock sold at an average market price of $25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant.
Instructions
Write Mr. Dolan a 1–1.5 page letter explaining why the warrants are not included in the calculation. FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B or can be accessed at the book’s companion website, www.wiley.com/college/kieso.
Instructions
Refer to P&G’s financial statements and accompanying notes to answer the following questions. (a) Under P&G’s stock-based compensation plan, stock options are granted annually to key managers and directors. (1) How many options were granted during 2009 under the plan? (2) How many options were exercisable at June 30, 2009? (3) How many options were exercised in 2009, and what was the average price of those exercised? (4) How many years from the grant date do the options expire? (5) To what accounts are the proceeds from these option exercises credited? (6) What was the number of outstanding options at June 30, 2009, and at what average exercise price? (b) What number of diluted weighted-average common shares outstanding was used by P&G in computing earnings per share for 2009, 2008, and 2007? What was P&G’s diluted earnings per share in 2009, 2008, and 2007? (c) What other stock-based compensation plans does P&G have? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What employee stock-option compensation plans are offered by Coca-Cola and PepsiCo? (b) How many options are outstanding at year-end 2009 for both Coca-Cola and PepsiCo? (c) How many options were granted by Coca-Cola and PepsiCo to officers and employees during 2009? (d) How many options were exercised during 2009? (e) What was the average exercise price for Coca-Cola and PepsiCo employees during 2009? (f) What are the weighted-average number of shares used by Coca-Cola and PepsiCo in 2009, 2008, and 2007 to compute diluted earnings per share? (g) What was the diluted net income per share for Coca-Cola and PepsiCo for 2009, 2008, and 2007? Financial Statement Analysis Cases Case 1 Kellogg Company Kellogg Company in its 2004 Annual Report in Note 1—Accounting Policies made the comment on page 962 about its accounting for employee stock options and other stock-based compensation. This was the annual report issued the year before the FASB mandated expensing stock options. USING YOUR JUDGMENT Using Your Judgment 961 Stock compensation (in part) The Company currently uses the intrinsic value method prescribed by Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” to account for its employee stock options and other stock-based compensation. Under this method, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized. The following table presents the pro forma results for the current and prior years, as if the Company had used the alternate fair value method of accounting for stockbased compensation, prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation” (as amended by SFAS No. 148). Stock-based compensation expense, net of tax: (millions, except per share data) 2004 2003 2002 As reported $11.4 $12.5 $10.7 Pro forma $41.8 $42.1 $52.8 Net earnings: As reported $890.6 $787.1 $720.9 Pro forma $860.2 $757.5 $678.8 Basic net earnings per share: As reported $2.16 $1.93 $1.77 Pro forma $2.09 $1.86 $1.66 Diluted net earnings per share: As reported $2.14 $1.92 $1.75 Pro forma $2.07 $1.85 $1.65 Under this pro forma method, the fair value of each option grant (net of estimated unvested forfeitures) was estimated at the date of grant using an option-pricing model and was recognized over the vesting period, generally two years. Refer to Note 8 for further information on the Company’s stock compensation programs. In December 2004, the FASB issued SFAS No. 123(Revised), “Share-Based Payment,” which generally requires public companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value and to recognize this cost over the requisite service period. The Company plans to adopt SFAS No. 123(Revised), as of the beginning of its 2005 fi scal third quarter and is currently considering retrospective restatement to the beginning of its 2005 fi scal year. Once this standard is adopted, management believes full-year fi scal 2005 net earnings per share will be reduced by approximately $.08.
Instructions
(a) Briefly discuss how Kellogg’s financial statements were affected by the adoption of the new standard. (b) Some companies argued that the recognition provisions of the standard are not needed because the computation of earnings per share takes into account dilutive securities such as stock options. Do you agree? Explain, using the Kellogg disclosure provided above. Case 2 Sepracor, Inc. Sepracor, Inc., a drug company, reported the following information. The company prepares its financial statements in accordance with GAAP. 2007 (,000) Current liabilities $ 554,114 Convertible subordinated debt 648,020 Total liabilities 1,228,313 Stockholders’ equity 176,413 Net income 58,333 Analysts attempting to compare Sepracor to drug companies that issue debt with detachable warrants may face a challenge due to differences in accounting for convertible debt.
Instructions
(a) Compute the following ratios for Sepracor, Inc. (Assume that year-end balances approximate annual averages.) (1) Return on assets. (2) Return on stockholders’ equity. (3) Debt to assets ratio. (b) Briefly discuss the operating performance and financial position of Sepracor. Industry averages for these ratios in 2007 were: ROA 3.5%; return on equity 16%; and debt to assets 75%. Based on this analysis, would you make an investment in the company’s 5% convertible bonds? Explain. (c) Assume you want to compare Sepracor to an IFRS company like Merck (which issues nonconvertible debt with detachable warrants). Assuming that the fair value of the equity component of Sepracor’s convertible bonds is $150,000, how would you adjust the analysis above to make valid comparisons between Sepracor and Merck? Accounting, Analysis, and Principles On January 1, 2011, Garner issued 10-year, $200,000 face value, 6% bonds at par. Each $1,000 bond is convertible into 30 shares of Garner $2 par value common stock. The company has had 10,000 shares of common stock (and no preferred stock) outstanding throughout its life. None of the bonds have been converted as of the end of 2012. (Ignore all tax effects.) Accounting (a) Prepare the journal entry Garner would have made on January 1, 2011, to record the issuance of the bonds. (b) Garner’s net income in 2012 was $30,000 and was $27,000 in 2011. Compute basic and diluted earnings per share for Garner for 2012 and 2011. (c) Assume that 75 percent of the holders of Garner’s convertible bonds convert their bonds to stock on June 30, 2013, when Garner’s stock is trading at $32 per share. Garner pays $50 per bond to induce bondholders to convert. Prepare the journal entry to record the conversion. Analysis Show how Garner will report income and EPS for 2012 and 2011. Briefly discuss the importance of GAAP for EPS to analysts evaluating companies based on price-earnings ratios. Consider comparisons for a company over time, as well as comparisons between companies at a point in time. Principles In order to converge GAAP and IFRS, the FASB is considering whether the equity element of a convertible bond should be reported as equity. Describe how the journal entry you made in part (a) above would differ under IFRS. In terms of the accounting principles discussed in Chapter 2, what does IFRS for convertible debt accomplish that GAAP potentially sacrifices? What does GAAP for convertible debt accomplish that IFRS potentially sacrifices? BRIDGE TO THE PROFESSION
Professional Research: FASB Codifi cation
Richardson Company is contemplating the establishment of a share-based compensation plan to provide long-run incentives for its top management. However, members of the compensation committee of the board of directors have voiced some concerns about adopting these plans, based on news accounts related to a recent accounting standard in this area. They would like Using Your Judgment 963 you to conduct some research on this recent standard so they can be better informed about the accounting for these plans.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Identify the authoritative literature that addresses the accounting for share-based payment compensation plans. (b) Briefl y discuss the objectives for the accounting for stock compensation. What is the role of fair value measurement? (c) The Richardson Company board is also considering an employee share-purchase plan, but the Board does not want to record expense related to the plan. What criteria must be met to avoid recording expense on an employee stock-purchase plan?
Professional Simulation
In this simulation, you are asked to address questions related to the accounting for stock options and earnings per share computations. Prepare responses to all parts.  Directions Situation Explanation Financial Statements Resources On the basis of the information above, do you agree with the controller’s computation of earnings per share for the year? If you disagree, prepare a revised computation of earnings per share. As auditor for Banquo & Associates, you have been assigned to check Duncan Corporation’s computation of earnings per share for the current year. The controller, Mac Beth, has supplied you with the following computations. Net income $3,374,960 Common shares issued and outstanding: Beginning of year 1,285,000 End of year 1,200,000 Average 1,242,500 Earnings per share: You have developed the following additional information. 1. There are no other equity securities in addition to the common shares. 2. There are no options or warrants outstanding to purchase common shares. 3. There are no convertible debt securities. 4. Activity in common shares during the year was as follows. Outstanding, Jan. 1 1,285,000 Treasury shares acquired, Oct. 1 1,035,000 Shares reissued, Dec. 1 165,000 Outstanding, Dec. 31 1,200,000 = $2.72 per share 1,242,500 $3,374,960 (250,000) Directions Situation Explanation Financial Statements Resources Directions Situation Explanation Financial Statements Resources Assume the same facts as those presented above, except that options had been issued to purchase 140,000 shares of common stock at $10 per share. These options were outstanding at the beginning of the year, and none had been exercised or canceled during the year. The average market price of the common shares during the year was $25, and the ending market price was $35. What earnings per share amounts will be reported? 1 2 3 45 A B C + KWW_Professional_Simulation Stock Options and EPS Time Remaining 3 hours 50 minutes Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit The primary IFRS related to fi nancial instruments, including dilutive securities, is IAS 39, “Financial Instruments: Recognition and Measurement.” The accounting for various forms of stock-based compensation under IFRS is found in IFRS 2, “Share-Based Payment.” This standard was recently amended, resulting in signifi cant convergence between IFRS and GAAP in this area. The IFRS addressing accounting and reporting for earnings per share computations is IAS 33, “Earnings per Share.” RELEVANT FACTS • A signifi cant difference between IFRS and GAAP is the accounting for securities with characteristics of debt and equity, such as convertible debt. Under 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. • Both IFRS and GAAP follow the same model for recognizing stock-based compensation: The fair value of shares and options awarded to employees is recognized over the period to which the employees’ services relate. • Related to employee share-purchase plans, under IFRS all employee share-purchase plans are deemed to be compensatory; that is, compensation expense is recorded for the amount of the discount. Under GAAP, these plans are often considered noncompensatory and therefore no compensation is recorded. Certain conditions must exist before a plan can be considered noncompensatory—the most important being that the discount generally cannot exceed 5%. • Modifi cation of a share option results in the recognition of any incremental fair value under both IFRS and GAAP. However, if the modifi cation leads to a reduction, IFRS does not permit the reduction but GAAP does. • Although the calculation of basic and diluted earnings per share is similar between IFRS and GAAP, the Boards are working to resolve the few minor differences in EPS reporting. One proposal in the FASB project concerns contracts that can be settled in either cash or shares. IFRS requires that share settlement must be used, while GAAP gives companies a choice. The FASB project proposes adopting the IFRS approach, thus converging GAAP and IFRS in this regard. • Other EPS differences relate to (1) the treasury-stock method and how the proceeds from extinguishment of a liability should be accounted for, and (2) how to compute the weighted average of contingently issuable shares. ABOUT THE NUMBERS Accounting for Convertible Debt Convertible debt is accounted for as a compound instrument because it contains both a liability and an equity component. IFRS requires that compound instruments be separated into their liability and equity components for purposes of accounting. Companies use the “with-and-without” method to value compound instruments. Illustration
IFRS16-1 identifi es the components used in the with-and-without method.
IFRS Insights IFRS Insights 965 ILLUSTRATION
IFRS16-1
Convertible Debt Components Fair value of convertible debt at date of issuance (with both debt and equity components) Fair value of liability component at date of issuance, based on present value of cash fl ows Equity component at date of issuance (without the debt component) 2 5 As indicated, the equity component is the residual amount after subtracting the liability component. IFRS does not permit companies to assign a value to the equity amount fi rst and then determine the liability component. To do so would be inconsistent with the defi nition of equity, which is considered a residual amount. To implement the with-andwithout approach, companies do the following. 1. First, the company determines the total fair value of the convertible debt with both the liability and equity component. This is straightforward, as this amount is the proceeds received upon issuance. 2. The company then determines the liability component by computing the net present value of all contractual future cash fl ows discounted at the market rate of interest. This market rate is the rate the company would pay on similar nonconvertible debt. 3. In the fi nal step, the company subtracts the liability component estimated in the second step from the fair value of the convertible debt (issue proceeds) to arrive at the equity component. That is, the equity component is the fair value of the convertible debt without the liability component Accounting at Time of Issuance To illustrate the accounting for convertible debt, assume that Roche Group issues 2,000 convertible bonds at the beginning of 2011. 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 nonconvertible debt is 9 percent. The time diagram in Illustration
IFRS16-2 depicts both the interest and principal cash fl ows.
ILLUSTRATION
IFRS16-2
Time Diagram for Convertible Bond The liability component of the convertible debt is computed as shown in Illustration
IFRS16-3.
ILLUSTRATION
IFRS16-4
Equity Component of Convertible Bond Fair value of convertible debt at date of issuance $2,000,000 Less: Fair value of liability component at date of issuance 1,805,626 Fair value of equity component at date of issuance $ 194,374 ILLUSTRATION
IFRS16-3
Fair Value of Liability Component of Convertible Bond Present value of principal: $2,000,000 3 .70843 (Table 6-2; n 5 4, i 5 9%) $1,416,860 Present value of the interest payments: $120,000 3 3.23972 (Table 6-4; n 5 4, i 5 9%) 388,766 Present value of the liability component $1,805,626 The equity component of Roche’s convertible debt is then computed as shown in Illustration
IFRS16-4.
0 1 2 3 4 i = 9% $120,000 $120,000 $120,000 $120,000 Interest $2,000,000 Principal n = 4 PV–OA PV The journal entry to record this transaction is as follows. Cash 2,000,000 Bonds Payable 1,805,626 Share Premium—Conversion Equity 194,374 The liability component of Roche’s convertible debt issue is recorded as Bonds Payable. As shown in Chapter 14, the amount of the discount relative to the face value of the bond is amortized at each reporting period so at maturity, the Bonds Payable account is reported at $2,000,000 (face value). The equity component of the convertible bond is recorded in the Share Premium—Conversion Equity account and is reported in the equity section of the statement of fi nancial position. Because this amount is considered part of contributed capital, it does not change over the life of the convertible. Transaction costs related to the liability and equity components are allocated in proportion to the proceeds received from the two components. For purposes of homework, use the Share Premium—Conversion Equity account to record the equity component. In practice, there may be considerable variation in the accounts used to record this component. Settlement of Convertible Bonds We illustrate four settlement situations: (1) repurchase at maturity, (2) conversion at maturity, (3) conversion before maturity, and (4) repurchase before maturity. Repurchase at Maturity. If the bonds are not converted at maturity, Roche makes the following entry to pay off the convertible debtholders. Bonds Payable 2,000,000 Cash 2,000,000 (To record the purchase of bonds at maturity) Because the carrying value of the bonds equals the face value, there is no gain or loss on repurchase at maturity. The amount originally allocated to equity of $194,384 either remains in the Share Premium—Conversion Equity account or is transferred to Share Premium—Ordinary. Conversion of Bonds at Maturity. If the bonds are converted at maturity, Roche makes the following entry. Share Premium—Conversion Equity 194,374 Bonds Payable 2,000,000 Share Capital—Ordinary 500,000 Share Premium—Ordinary 1,694,374 (To record the conversion of bonds at maturity) As indicated, Roche records a credit to Share Capital—Ordinary for $500,000 (2,000 bonds 3 250 shares 3 $1 par) and the remainder to Share Premium—Ordinary for $1,694,374. There is no gain or loss on conversion at maturity. The original amount allocated to equity ($194,374) is transferred to the Share Premium—Ordinary account. As a result, Roche’s equity has increased by a total of $2,194,374 through issuance and conversion of the convertible bonds. This accounting approach is often referred to as the book value method in that the carrying amount (book value) of the bond and related conversion equity determines the amount in the ordinary equity accounts. Conversion of Bonds before Maturity. What happens if bonds are converted before maturity? To understand the accounting, we again use the Roche Group example. A schedule of bond amortization related to Roche’s convertible bonds is shown in Illustration
IFRS16-5 (page 968).
IFRS Insights 967 Assuming that Roche converts its bonds into ordinary shares on December 31, 2012, Roche debits the Bonds Payable account for its carrying value of $1,894,464 (see Illustration
IFRS16-5). In addition, Roche credits Share Capital—Ordinary for $500,000 (2,000
3 250 3 $1) and credits Share Premium—Ordinary for $1,588,838. The entry to record this conversion is as follows. Share Premium—Conversion Equity 194,374 Bonds Payable 1,894,464 Share Capital—Ordinary 500,000 Share Premium—Ordinary 1,588,838 (To record the conversion of bonds before maturity) There is no gain or loss on conversion before maturity: The original amount allocated to equity ($194,374) is transferred to the Share Premium—Ordinary account. Repurchase before Maturity. In some cases, companies decide to repurchase the convertible debt before maturity. The approach used for allocating the amount paid upon repurchase follows the approach used when the convertible bond was originally issued. That is, Roche determines the fair value of the liability component of the convertible bonds at December 31, 2012, and then subtracts this amount from the fair value of the convertible bond issue (including the equity component) to arrive at the value for the equity. After this allocation is completed: 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. To illustrate, instead of converting the bonds on December 31, 2012, assume that Roche repurchases the convertible bonds from the bondholders. Pertinent information related to this conversion is as follows. • Fair value of the convertible debt (including both liability and equity components), based on market prices at December 31, 2012, 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 nonconvertible bond with a two-year term (which corresponds to the shortened time to maturity of the repurchased bonds). We first determine the gain or loss on the liability component, as computed in Illustration
IFRS16-6.
ILLUSTRATION
IFRS16-5
Convertible Bond Amortization Schedule ILLUSTRATION
IFRS16-6
Gain or Loss on Debt Repurchase Present value of liability component at December 31, 2012 (given above) $ 1,904,900 Carrying value of liability component at December 31, 2012 (per Illustration
IFRS16-5) (1,894,464)
Loss on repurchase $ 10,436 SCHEDULE OF BOND AMORTIZATION EFFECTIVE-INTEREST METHOD 6% BOND DISCOUNTED AT 9% Cash Interest Discount Carrying Amount Date Paid Expense Amortized of Bonds 1/1/11 $1,805,626 12/31/11 $120,000 $162,506 $42,506 1,848,132 12/31/12 120,000 166,332 46,332 1,894,464 12/31/13 120,000 170,502 50,502 1,944,966 12/31/14 120,000 175,034* 55,034 2,000,000 *$13 difference due to rounding. Roche has a loss on this repurchase because the value of the debt extinguished is greater than its carrying amount. To determine any adjustment to the equity, we compute the value of the equity as shown in Illustration
IFRS16-7.
ILLUSTRATION
IFRS16-7
Equity Adjustment on Repurchase of Convertible Bonds Fair value of convertible debt at December 31, 2012 (with equity component) $1,965,000 Less: Fair value of liability component at December 31, 2012 (similar 2-year nonconvertible debt) 1,904,900 Fair value of equity component at December 31, 2012 (without debt component) $ 60,100 Roche makes the following compound journal entry to record the entire repurchase transaction. Bonds Payable 1,894,464 Share Premium—Conversion Equity 60,100 Loss on Repurchase 10,436 Cash 1,965,000 (To record the repurchase of convertible bonds) In summary, the repurchase results in a loss related to the liability component and a reduction in Share Premium—Conversion Equity. The remaining balance in Share Premium—Conversion Equity of $134,274 ($194,374 2 $60,100) is often transferred to Share Premium—Ordinary upon the repurchase. Employee Share-Purchase Plans Employee share-purchase plans (ESPPs) generally permit all employees to purchase shares at a discounted price for a short period of time. The company often uses such plans to secure equity capital or to induce widespread ownership of its ordinary shares among employees. These plans are considered compensatory and should be recorded as expense over the service period. To illustrate, assume that Masthead Company offers all its 1,000 employees the opportunity to participate in an employee share-purchase plan. Under the terms of the plan, the employees are entitled to purchase 100 ordinary shares (par value $1 per share) at a 20 percent discount. The purchase price must be paid immediately upon acceptance of the offer. In total, 800 employees accept the offer, and each employee purchases on average 80 shares. That is, the employees purchase a total of 64,000 shares. The weightedaverage market price of the shares at the purchase date is $30 per share, and the weighted-average purchase price is $24 per share. The entry to record this transaction is as follows. Cash (64,000 3 $24) 1,536,000 Compensation Expense [64,000 3 ($30 2 $24)] 384,000 Share Capital—Ordinary (64,000 3 $1) 64,000 Share Premium—Ordinary 1,856,000 (Issue shares in an employee share-purchase plan) The IASB indicates that there is no reason to treat broad-based employee share plans differently from other employee share plans. Some have argued that because these plans are used to raise capital, they should not be compensatory. However, IFRS requires recording expense for these arrangements. The Board notes that because these arrangements are available only to employees, it is sufficient to conclude that the benefits provided represent employee compensation. 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 FASB, the IASB is examining the classification of hybrid securities; the IASB is seeking comment on a discussion document IFRS Insights 969 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. While GAAP and IFRS are similar as to the presentation of EPS, the Boards have been working together to resolve remaining differences related to earnings per share computations.
IFRS SELF-TEST QUESTIONS

1.
All of the following are key similarities between GAAP and IFRS with respect to accounting for dilutive securities and EPS except: (a) the model for recognizing stock-based compensation. (b) the calculation of basic and diluted EPS. (c) the accounting for convertible debt. (d) the accounting for modifi cations of share options, when the value increases.
2.
Which of the following statements is correct? (a) IFRS separates the proceeds of a convertible bond between debt and equity by determining the fair value of the debt component before the equity component. (b) Both IFRS and GAAP assume that when there is choice of settlement of an option for cash or shares, share settlement is assumed. (c) IFRS separates the proceeds of a convertible bond between debt and equity, based on relative fair values. (d) Both GAAP and IFRS separate the proceeds of convertible bonds between debt and equity.
3.
Under IFRS, convertible bonds: (a) are separated into the bond component and the expense component. (b) are separated into debt and equity components. (c) are separated into their components based on relative fair values. (d) All of the above.
4.
Mae Jong Corp. issues $1,000,000 of 10% bonds payable which may be converted into 10,000 shares of $2 par value ordinary shares. The market rate of interest on similar bonds is 12%. Interest is payable annually on December 31, and the bonds were issued for total proceeds of $1,000,000. In accounting for these bonds, Mae Jong Corp. will: (a) fi rst assign a value to the equity component, then determine the liability component. (b) assign no value to the equity component since the conversion privilege is not separable from the bond. (c) fi rst assign a value to the liability component based on the face amount of the bond. (d) use the “with-and-without” method to value the compound instrument.
5.
Anazazi Co. offers all its 10,000 employees the opportunity to participate in an employee share-purchase plan. Under the terms of the plan, the employees are entitled to purchase 100 ordinary shares (par value $1 per share) at a 20 percent discount. The purchase price must be paid immediately upon acceptance of the offer. In total, 8,500 employees accept the offer, and each employee purchases on average 80 shares at $22 share (market price $27.50). Under IFRS, Anazazi Co. will record: (a) no compensation since the plan is used to raise capital, not compensate employees. (b) compensation expense of $5,500,000. (c) compensation expense of $18,700,000. (d) compensation expense of $3,740,000. IFRS CONCEPTS AND APPLICATION
IFRS16-1
Where can authoritative IFRS be found related to dilutive securities, stockbased compensation, and earnings per share?
IFRS16-2
Briefl y describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for dilutive securities, stock-based compensation, and earnings per share.
IFRS16-3
Norman Co., a fast-growing golf equipment company, uses GAAP. It is considering the issuance of convertible bonds. The bonds mature in 10 years, have a face value of $400,000, and pay interest annually at a rate of 4%. The estimated fair value of the equity portion of the bond issue is $35,000. Greg Shark is curious as to the difference in accounting for these bonds if the company were to use IFRS. (a) Prepare the entry to record issuance of the bonds at par under GAAP. (b) Repeat the requirement for part (a), assuming application of IFRS to the bond issuance. (c) Which approach provides the better accounting? Explain.
IFRS16-4
Briefl y discuss the convergence efforts that are under way by the IASB and FASB in the area of dilutive securities and earnings per share.
IFRS16-5
Explain how the conversion feature of convertible debt has a value (a) to the issuer and (b) to the purchaser.
IFRS16-6
What are the arguments for giving separate accounting recognition to the conversion feature of debentures?
IFRS16-7
Four years after issue, debentures with a face value of $1,000,000 and book value of $960,000 are tendered for conversion into 80,000 ordinary shares immediately after an interest payment date. At that time, the market price of the debentures is 104, and the ordinary shares are selling at $14 per share (par value $10). At date of issue, the company needed Share Premium—Conversion Equity of $50,000. The company records the conversion as follows. Bonds Payable 960,000 Share Premium—Conversion Equity 50,000 Share Capital—Ordinary 800,000 Share Premium—Ordinary 210,000 Discuss the propriety of this accounting treatment.
IFRS16-8
Cordero Corporation has an employee share-purchase plan which permits all full-time employees to purchase 10 ordinary shares on the third anniversary of their employment and an additional 15 shares on each subsequent anniversary date. The purchase price is set at the market price on the date purchased less a 10% discount. How is this discount accounted for by Cordero?
IFRS16-9
Archer Company issued $4,000,000 par value, 7% convertible bonds at 99 for cash. The net present value of the debt without the conversion feature is $3,800,000. Prepare the journal entry to record the issuance of the convertible bonds.
IFRS16-10
Petrenko Corporation has outstanding 2,000 $1,000 bonds, each convertible into 50 shares of $10 par value ordinary shares. The bonds are converted on December 31, 2012. The bonds payable has a carrying value of $1,950,000 and conversion equity of $20,000. Record the conversion using the book value method.
IFRS16-11
Angela Corporation issues 2,000 convertible bonds at January 1, 2011. The bonds have a three-year life, and are issued at par with a face value of $1,000 per bond, giving total proceeds of $2,000,000. Interest is payable annually at 6 percent. Each bond is convertible into 250 ordinary shares (par value of $1). When the bonds are issued, the market rate of interest for similar debt without the conversion option is 8%.
IFRS Insights 971
Instructions
(a) Compute the liability and equity component of the convertible bond on January 1, 2011. (b) Prepare the journal entry to record the issuance of the convertible bond on January 1, 2011. (c) Prepare the journal entry to record the repurchase of the convertible bond for cash at January 1, 2014, its maturity date.
IFRS16-12
Assume the same information in
IFRS16-11, except that Angela Corporation converts its convertible bonds on January 1, 2012.

Instructions
(a) Compute the carrying value of the bond payable on January 1, 2012. (b) Prepare the journal entry to record the conversion on January 1, 2012. (c) Assume that the bonds were repurchased on January 1, 2012, for $1,940,000 cash instead of being converted. The net present value of the liability component of the convertible bonds on January 1, 2012, is $1,900,000. Prepare the journal entry to record the repurchase on January 1, 2012.
IFRS16-13
Assume that Sarazan Company has a share-option plan for top management. Each share option represents the right to purchase a $1 par value ordinary share in the future at a price equal to the fair value of the shares at the date of the grant. Sarazan has 5,000 share options outstanding, which were granted at the beginning of 2012. The following data relate to the option grant. Exercise price for options $40 Market price at grant date (January 1, 2012) $40 Fair value of options at grant date (January 1, 2012) $6 Service period 5 years
Instructions
(a) Prepare the journal entry(ies) for the fi rst year of the share-option plan. (b) Prepare the journal entry(ies) for the fi rst year of the plan assuming that, rather than options, 700 shares of restricted shares were granted at the beginning of 2012. (c) Now assume that the market price of Sarazan shares on the grant date was $45 per share. Repeat the requirements for (a) and (b). (d) Sarazan would like to implement an employee share-purchase plan for rankand- fi le employees, but it would like to avoid recording expense related to this plan. Explain how employee share-purchase plans are recorded. Professional Research
IFRS16-14
Richardson Company is contemplating the establishment of a share-based compensation plan to provide long-run incentives for its top management. However, members of the compensation committee of the board of directors have voiced some concerns about adopting these plans, based on news accounts related to a recent accounting standard in this area. They would like you to conduct some research on this recent standard so they can be better informed about the accounting for these plans.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/ ). When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) Identify the authoritative literature that addresses the accounting for sharebased payment compensation plans.  (b) Briefl y discuss the objectives for the accounting for share-based compensation. What is the role of fair value measurement? (c) The Richardson Company board is also considering an employee sharepurchase plan, but the Board does not want to record expense related to the plan. What are the IFRS requirements for the accounting for an employee share-purchase plan?
International Financial Reporting Problem:

Marks and Spencer plc

IFRS16-15
The fi nancial statements of Marks and Spencer plc (M&S) are available at the books’ companion website or can be accessed at http://corporate.marksandspencer. com/documents/publications/2010/Annual_Report_2010.
Instructions
Refer to M&S’s fi nancial statements and the accompanying notes to answer the following questions. (a) Under M&S’s share-based compensation plan, share options are granted annually to key managers and directors. (1) How many options were granted during 2010 under the plan? (2) How many options were exercisable at April 3, 2010? (3) How many options were exercised in 2010, and what was the average price of those exercised? (4) How many years from the grant date do the options expire? (5) To what accounts are the proceeds from these option exercises credited? (6) What was the number of outstanding options at April 3, 2010, and at what average exercise price? (b) What number of diluted weighted-average shares outstanding was used by M&S in computing earnings per share for 2010 and 2009? What was M&S’s diluted earnings per share in 2010 and 2009? (c) What other share-based compensation plans does M&S have?
ANSWERS TO IFRS SELF-TEST QUESTIONS
1. c 2. a 3. b 4. d 5. d




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