Ch 16 Flashcards
How are preferred stock and options classified?
As liabilities
Why should companies classify non redeemable shares as equity?
Because issuer has no obligation to pay dividends or repurchase
The stock
Dilutive securities
Upon exercise may dilute EPS
ex. Convertible securities, options, warrants
Convertible bonds
Can be changed into other corporate securities during some
specified period after issuance
Why do corporations issue convertibles? 2 reasons
1 raise equity capital
2 obtain debt financing at cheaper rates
The accounting for convertible debt involves reporting issues at 3 times
Time of:
1 issuance
2 conversion
3 retirement
IFRS requires that the issuer of convertible debt record the…
Liability and equity components separately
Method of recording convertible bonds at time of issuance
Follows method used to record straight debt issues, none
Of the proceeds are recorded as equity
Companies amortize to maturity date any discount or premium
Converting bonds into other securities, what method is used to record conversion?
Book value method
Book value method
Records the securities exchanged for the bond at the carrying
Amount (book value) of the bond
Induce conversion
Additional consideration such as cash or common stock, called
A “sweetener”
When do induced conversions occur?
When issuer wishes to encourage prompt conversion of its
Convertible debt to equity securities
To reduce interest costs or improve debt to equity ratio
Accounting treatment of induced conversions
Expensed in the current period
Retiring convertible debt, what must companies recognize?
Companies need to recognize gain or loss on retiring convertible
Debt
in same way they recognize gain or loss in retiring non convertible
Debt
Retirement of debt: reporting differences between cash acquisition price of debt and it’s carrying amount
Reported in current income as gain or loss
Convertible preferred stock
Includes option for holder to convert preferred shares into fixed
Number of common shares
When convertible preferred stock exercised, company does
Not recognize a gain or loss
Difference between classification of convertible preferred (where no mandatory redemption exists) and convertible bonds
Convertible preferred considered part of stockholders equity
Convertible bonds considered liability
What accounting method is used when convertible preferred stock is exercised?
Book value method
Warrants
Certificates entitling the holder to acquire shares of stock at
Certain price within stated period
Warrants when exercised have dilutive effect on EPS
Difference between convertible securities and stock warrants
Upon exercise of warrants holder has to pay certain amount
Of money to obtain shares
3 situations for issuance if warrants or options to buy additional shares
1 make security more attractive in deal
2 preemptive right to purchase common stock first
3 executive and employee compensation
Detachable stock warrant
Can be separated form stock and traded as separate security
Warrants issued with other securities
Long term options to buy common stock at fixed price
Generally life of warrants is 5 years or 10 years
A company should allocate the proceeds from the sale of debt with detachable stock warrants between…
The 2 securities
2 methods of allocation between warrants issued with other securities
1 proportional method
2 incremental method
Proportional method
Allocates proceeds using proportion of 2 amounts based on fair
Values
Incremental method
Used when fair value can’t be determined
Allocates known fair value to security and then allocates purchase
Price when fair value is unknown
Inseparable feature (convertible security)
Choices are mutually exclusive
Holder either converts the bond or redeems cash, but can’t
Do both
Detachable warrants
Involves 2 securities, 1 debt security remains outstanding until
Maturity
And the other a warrant to purchase common stock
This justifies separate accounting treatment
Nondetachable warrants
Don’t require allocation of proceeds btw/bonds and warrants
Similar to convertible bonds, companies record entire proceeds
From Nondetachable warrants as debt
Preemptive privilege AKA stock right
To purchase newly issued shares in proportion to their holdings
What does preemptive privilege/stock right do for existing shareholders?
Saves existing shareholders from suffering a dilution of voting
rights without their consent
May allow for purchase of stock below its fair value
Companies make only a memorandum entry when they…
Issue rights to existing stockholders
Stock option
Warrant which gives key employees the option to purchase
common stock at given price over extended period of time
Stock based compensation plans
Provide employee opportunity to receive stock if performance
Of company by whatever measure is satisfactory
Option expense is much smaller element of compensation relative to restricted stock. 2 major reasons
1 manipulation of accounting numbers by executives to achieve
Higher share price to get compensated with options
2 GAAP results in companies recording higher expense when
Stock options are granted
Grant date
Date you receive options
IFRS follows the same model as GAAP for recognizing…
Share based compensation
Intrinsic value method (granted stock options)
Measures compensation cost by excess of market price of stock
Over its exercise price at grant date
Intrinsic value method measures what holder would receive today
If option was immediately exercised
Intrinsic value
Difference between market price of stock and exercise price
Of options at grant date
Fair value method (granted stock options)
Companies use acceptable option-pricing models to value the
Options at date of grant
GAAP requires companies recognize compensation cost using…
Fair value method
4 major factors of option pricing
1 volatility of underlying stock
2 expected life of options
3 risk-free rate during option life
4 expected dividends during option life
2 main accounting issues for stock option plans
1 how to determine compensation expense
2 over what periods to allocate compensation expense
Stock options fair value method
Companies compute total compensation expense based on
FMV of options expected to vest on date they grant options to
Employees
Service period AKA Vesting period
Time between grant date and vesting date
Periods in which employees perform the service
To vest
To earn the rights to
Employees award becomes vested at date that the employee’s
right to receive or retain shares or cash under award no longer
Depends on remaining service to employer
Restricted stock plans
Transfer shares of stock to employees,
subject to agreement that shares can’t be sold, transferred or
Pledged until vesting occurs
3 major advantages of restricted stock plans
1 restricted stock never becomes worthless
2 restricted stock results in less dilution to existing shareholders
3 restricted stock better aligns employee incentives with
Companies incentives
Restricted stock results in less dilution to existing shareholders
Restricted stock awards usually 1/2 to 1/3 the size of stock options
Unearned compensation
Cost of services yet to be performed
Not an asset
Employee stock-purchase plans (ESPPs)
Generally permit all employees to purchase stock at discounted
Price for short period of time
What 3 conditions must be satisfied for employee stock purchase plans (ESPPs) to not be considered compensatory?
1 substantially all full time employees may participate on equitable
Basis
2 discount from market is 5% or less
3 plan offers no substantive option feature
IFRS requires than any discount from market price on stock purchase plans be recorded as…
Compensation expense
4 requirements for disclosure of compensation plans
1 nature and terms of plans and how they affect Shareholders
2 effect on income statement of compensation cost
3 method of estimating FMV of goods or services received
Or FMV of equity instruments granted
4 cash flow effects from share based payment plans
How did companies overstate earnings in the S&P 500 by 10 percent?
How did companies resist overstating earnings?
Through use of the intrinsic value method (overstate)
Accurately stated through use of fair value method
Earnings per share
Indicates income earned by each share of common stock
When is a corporations capital structure simple?
When it consists only of common stock
or includes no Potential common stock that upon conversion
Or exercise could dilute earnings per common share
When is a capital structure complex
When it includes securities that could have dilutive effect on EPS
Earnings per share for common stock holders (when preferred shares exist) equation
EPS =
net income - preferred dividends)/(weighted avg. # SH. Outstanding
If a company declares dividends on preferred stock and a net loss occurs, how does the company compute the loss?
The company adds the preferred dividend to the loss to
Compute the loss per share
If the preferred stock is cumulative and the company has net income but declares no dividend in the current year, it…
Subtracts an amount equal to the dividend that should have
Been declared in current year only
If preferred stock is cumulative and company reports a net loss, but declares no dividend in current year, it…
Adds an amount equal to the dividend to the net loss
Where should dividend in arrears be included in computations?
Dividend in arrears included in previous year’s computations
Weighted average number of shares outstanding
Period shares are outstanding constitutes basis of per share
Amounts reported
Companies must weight shares by fraction of period they are
Outstanding
In determining the restatement of weighted avg. of shares outstanding what is restated?
Stock dividends and stock splits when they occur
Issuance or purchase of stock changes the amount of…
2) Are the weighted average of shares restated?
Net assets
2) weighted avg. of shares aren’t restated
Antidilutive securities
Securities that upon conversion or exercise increase EPS
or reduce loss per share
Diluted EPS equation
Diluted EPS equation =
(Net income - preferred dividends)/(weighted avg. # SH. Outstanding)
- impact of convertibles
- impact of options, warrants and other dilutive securities
If-converted method, how is it used?
How companies measure dilutive effects of potential conversion
On EPS
If-converted method, for convertible bonds assumes 2 things
1 conversion of convertible securities at beginning of period
Or time of issuance
2 elimination of related interest net of tax
The additional shares assumed issued…
Increase the denominator (the weighted avg. # of SH.)
The amount of interest expense, net if tax associated with potential common shares…
Increases the numerator (net income)
Treasury stock method
Used by companies to include options and warrants and their
Equivalents in EPS computations
What does the treasury stock method assume .
Options or warrants are exercised at beginning of year/issuance
Date
And company uses proceeds to purchase common stock for
The treasury
If the exercise price of the option or warrant is lower than market price of stock…
Dilution occurs
If exercise price of an option or warrant is higher than the market price of the stock it…
Reduces number of common shares
Its anti dilutive because leads to increase in EPS
Contingent shares
In business combinations the acquirer may promise to issue
Additional shares under certain conditions
2 conditions for contingent shares
1 passage of time condition
Or
2 attainment of certain earnings or market price level
When computing diluted EPS, what should a company exclude?
Including any securities that are anti dilutive in the calculation
5 additional disclosures in note form that capital structures and dual presentation of EPS require
1 description of pertinent rights and privileges of securities outstanding
2 reconciliation of numerators and denominators of basic and
Complex EPS
3 effect from preferred dividends on EPS
4 securities not included in current year that could dilute EPS in
Future
5 effect of conversions subsequent to year end but before issuance
