Chapter 16 Flashcards
Why do companies want to issue convertible bonds?
To raise capital and have lower interest payments (lower interest rates), more attractive to investors
What is the accounting entry for the issuance of convertible bonds?
Debit cash, credit bonds payable, parallels accounting for straight debt
What is a convertible bond?
Hybrid financial instrument composed of debt and equity
What does it mean to bifurcate a bond?
cut the instrument into two portions (debt and equity)
How are convertible bonds treated in international standards?
Always bifurcated
What happens at conversion of convertible bonds?
Book value of bonds is removed and replaced with common stock, discount and premiums also removed
Who initiates the conversion of convertible bonds?
the security holder
What type of expense are induced conversions?
period expenses
What are stock warrants/options?
Entitle the holder to acquire additional common stock within a stipulated period at a specified period
What effect do stock warrants have on EPS?
a dilutive effect
What happens upon exercise of a stock warrant?
cash is received by the issuer
In what ways can stock warrants be issued?
independently or with another security
What are the types of stock warrants issued with other securities?
detachable and non-detachable
How are detachable warrants treated?
bifurcated because they exist separately
How are nondetachable warrants treated?
treated like convertible bonds, cannot be bifurcated because they cannot exist seperately
What methods are used to determine the value of a detachable warrant?
proportional method and incremental method
What method is used if the warrant is nondetachable?
no allocation to warrants is made
When is the proportional method used?
When both the FMV of the bonds and warrants are known
When is the incremental method used?
When only one of the FMV of the bonds or warrants are known
Proportional Method of Allocation
(FMV of bonds or warrants/Total FMV of bonds and warrants) x par value/issuance price
Incremental Method of Allocation
total receipt (par value) - known FMV of bonds or warrants = FMV of unknown
What is the purpose of stock compensation plans?
to provide employees incentives that align with shareholders, provide motivation
What are types of stock compensation plans?
stock option plans, stock appreciation plans, and performance plans
How is the value of compensation determined?
The Black Scholes Model
What is the result of the intrinsic method of measuring compensation (old)?
results in overstating of earnings, no compensation expense recognized because few companies used fair value method, and options granted disproportionately to top executives
How is compensation expense currently accounted for?
debit compensation expense, credit paid in capital (stock options)
What are stock appreciation rights?
not paying anything out of pocket but get stock appreciation when price goes up
What is the result of stock appreciation rights?
No risk for employees
What is the purpose of reporting earnings per share?
allows us to compare between companies and it is the driver of a company’s stock price
Where are earnings per share reported?
Income Statement
What is the main focus for investors?
Earnings per Share
What is dilution?
reduction in EPS which results from conversion of other securities into common stock
What is purpose of reporting diluted earnings per share?
shareholders want to know extent of reduction in EPS if dilution takes place, report worst case scenario
What is the relationship between basic and diluted EPS?
Basic EPS is always higher than diluted EPS
How is basic EPS calculated?
(Net Income-Preferred Dividends)/Weighted Average Outstanding Common Shares
What is a simple capital structure?
common stock only with no potentially dilutive securities
When are preferred dividends subtracted?
when cumulative or declared
What is complex capital structure?
Have potentially dilutive securities such as convertible bonds or preferred stock, options or warrants or other rights that could reduce EPS
What are dilutive securities?
securities that could reduce EPS
What are anti-dilutive securities?
securities that could increase EPS
How is diluted EPS calculated?
((Net Income - Preferred Dividends)/Weighted Average Outstanding Common Shares) - Impact of Convertibles - Impact of warrants, options, and other dilutive securities
How is the dilutive effect of convertible securities measured?
if-converted method
How is the dilutive effect of options and warrants measured?
treasury stock method
What are the 3 differences between SARS and Stock Options?
1) No cash payout by employee, 2) Incorporate market price, 3) Record Liability
Process of Computing Diluted EPS
1) If-Converted Method for convertible bonds - Interest Savings/New Shares, 2) Treasury Stock Method for stock options - Cash Proceeds, buy back treasury stock, and calculate change in shares
What is restricted stock?
Gives employees a certain number of stocks in a certain day and can never go underwater
