Features of Preference Shares

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Questions and Answers

What is the journal entry on the date of distribution for an ordinary share dividend?

Debit Ordinary Share Dividend Distributable and credit Retained Earnings

Debit Retained Earnings and credit Ordinary Share Dividend Distributable

Debit Share Capital — Ordinary and credit Ordinary Share Dividend Distributable

Debit Ordinary Share Dividend Distributable and credit Share Capital — Ordinary (correct)

What is the purpose of a share split?

To reduce the market value of shares (correct)

To increase the par value of shares

To increase the market value of shares

To decrease the number of shares outstanding

What happens to the par value of shares in a share split?

It increases

It decreases (correct)

It becomes zero

It remains the same

What is the effect of a share dividend on the total par value of outstanding shares?

It increases Signup and view all the answers

How does a share split affect the number of shares outstanding?

It increases the number of shares Signup and view all the answers

What is the main difference between a share split and a share dividend?

A share split decreases par value, while a share dividend does not Signup and view all the answers

What happens to the par value per share in a share split?

It decreases Signup and view all the answers

Why is a share dividend different from a share split?

A share dividend does not change par value, while a share split decreases par value Signup and view all the answers

What is the effect of a share dividend on the number of shares outstanding?

It increases the number of shares Signup and view all the answers

What is recorded in a share split?

No entry is recorded Signup and view all the answers

What is the journal entry to issue convertible debt?

Debit Cash 2,000,000, Credit Bonds Payable 1,805,606, Credit Share Premium—Conversion Equity 194,394 Signup and view all the answers

If the bonds are not converted at maturity, what is the journal entry to pay off the convertible debtholders?

Debit Bonds Payable 2,000,000, Credit Cash 2,000,000 Signup and view all the answers

What is the amount allocated to equity in the journal entry to issue convertible debt?

€194,394 Signup and view all the answers

What is the market rate of interest on similar non-convertible debt?

9 percent Signup and view all the answers

What is the face value of each bond issued by Roche Group?

€1,000 Signup and view all the answers

What is the total proceeds received from the issuance of the bonds?

€2,000,000 Signup and view all the answers

How many ordinary shares can each bond be converted into?

250 Signup and view all the answers

What is the liability component of the convertible debt?

€1,805,606 Signup and view all the answers

What is the gain or loss on the liability component based on?

Present value of a non-convertible bond with a two-year term Signup and view all the answers

What is the purpose of the 'sweetener' in induced conversion?

To encourage prompt conversion of convertible debt Signup and view all the answers

What is the journal entry to record the repurchase of convertible bonds before maturity?

Debit Cash and credit Bonds Payable, Share Premium—Conversion Equity, and Loss on Repurchase Signup and view all the answers

What is the fair value of the liability component of the convertible debt?

€1,904,900 Signup and view all the answers

What is the effect of induced conversion on the equity component of convertible debt?

It increases the equity component Signup and view all the answers

What is the loss on repurchase of convertible bonds before maturity?

€10,436 Signup and view all the answers

What is the consideration allocated to the equity component of the convertible debt?

€60,100 Signup and view all the answers

What is the total fair value of the convertible debt?

€1,965,000 Signup and view all the answers

What is the primary reason corporations issue convertible debt?

To raise equity capital without giving up more ownership control than necessary. Signup and view all the answers

How is convertible debt accounted for?

As a compound instrument, using the with-and-without method. Signup and view all the answers

What is the first step in implementing the with-and-without approach for convertible debt?

Determine the total fair value of the convertible debt with both liability and equity components. Signup and view all the answers

What is the purpose of computing the net present value of contractual future cash flows in the with-and-without approach?

To determine the liability component of convertible debt. Signup and view all the answers

What is the main advantage of issuing convertible debt for corporations?

Raising equity capital without giving up more ownership control. Signup and view all the answers

What is the characteristics of convertible bonds?

Having both debt and equity characteristics. Signup and view all the answers

What is the main reason convertible debt is classified as a compound instrument?

Because it has both debt and equity characteristics. Signup and view all the answers

What is the purpose of the with-and-without method in accounting for convertible debt?

To separate the liability and equity components of convertible debt. Signup and view all the answers

What is the primary purpose of reporting earnings per share from continuing operations and net income on the face of the income statement?

To distinguish between recurring and non-recurring operations Signup and view all the answers

What is the term used to describe securities that could have a dilutive effect on earnings per ordinary share?

Dilutive securities Signup and view all the answers

How are preference dividends treated in the calculation of earnings per share?

Subtracted from net income Signup and view all the answers

What is the purpose of weighting the shares by the fraction of the period they are outstanding?

To calculate the weighted-average ordinary shares outstanding Signup and view all the answers

What is the term used to describe a capital structure that includes securities that could have a dilutive effect on earnings per ordinary share?

Complex capital structure Signup and view all the answers

Why do companies report earnings per share only for ordinary shares?

Because it is a regulatory requirement Signup and view all the answers

What is the formula to calculate earnings per share?

Net Income - Preference Dividends / Weighted-Average Ordinary Shares Outstanding Signup and view all the answers

When do companies need to restate the shares outstanding before a share dividend or split?

Before the share dividend or split is distributed Signup and view all the answers

What is the purpose of reporting both basic and diluted earnings per share?

To reflect the potential dilution of earnings per share Signup and view all the answers

What is the assumption made in the if-converted method for a convertible bond?

The conversion occurs at the beginning of the period or at the time of issuance Signup and view all the answers

What is the effect of antidilutive securities on the reporting of diluted earnings per share?

Is not reported in the financial statements Signup and view all the answers

What is the purpose of computing the net present value of contractual future cash flows in the with-and-without approach?

To determine the liability component of the convertible debt Signup and view all the answers

What is the term for a corporation that has convertible securities, options, warrants, or other rights that could dilute earnings per share?

Complex capital structure Signup and view all the answers

What is the purpose of disclosing the per-share amount for gain on discontinued operations?

To provide additional information to users of financial statements Signup and view all the answers

What is the main advantage of issuing convertible debt for corporations?

It increases the corporation's liquidity Signup and view all the answers

What is the main reason convertible debt is classified as a compound instrument?

Because it has both debt and equity components Signup and view all the answers

What is the relation between basic and diluted earnings per share?

Diluted EPS includes the effect of all potential dilutive ordinary shares Signup and view all the answers

What is the assumption made in calculating diluted earnings per share?

The conversion of convertible securities occurs at the beginning of the period or at the time of issuance Signup and view all the answers

What is the characteristics of convertible bonds?

They can be converted into ordinary shares Signup and view all the answers

What is the purpose of reporting comprehensive earnings per share?

To disclose the per-share amount for gain on discontinued operations Signup and view all the answers

What is the purpose of the 'sweetener' in induced conversion?

To induce conversion of the convertible debt Signup and view all the answers

What is the effect of induced conversion on the equity component of convertible debt?

It increases the equity component Signup and view all the answers

What is the journal entry to record the repurchase of convertible bonds before maturity?

Debit liability component, credit cash Signup and view all the answers

What is the primary reason corporations issue convertible debt?

To access capital with a lower interest rate Signup and view all the answers

What is the purpose of computing the weighted-average number of shares outstanding in a company?

To calculate the earnings per share of the company Signup and view all the answers

What is the effect of a share dividend on the total par value of outstanding shares?

It has no effect on the total par value of outstanding shares Signup and view all the answers

What is the purpose of assuming conversion of convertible preference shares to outstanding ordinary shares for EPS calculation?

To calculate the diluted earnings per share Signup and view all the answers

What is the difference between a share split and a share dividend?

A share split reduces the par value per share, while a share dividend increases it Signup and view all the answers

If each €100 preference share is convertible into 5 ordinary shares, how many ordinary shares will be issued if all preference shares are converted?

50,000 ordinary shares Signup and view all the answers

What happens to the number of shares outstanding in a share split?

It increases Signup and view all the answers

How does a share dividend affect the earnings per share of a company?

It decreases the earnings per share Signup and view all the answers

What is the net income available to ordinary shareholders if the net income is €240,000 and the preference dividend is €60,000?

€180,000 Signup and view all the answers

What is the purpose of declaring dividends on preference shares?

To distribute profits to preference shareholders Signup and view all the answers

What is the basic earnings per share if the net income available to ordinary shareholders is €180,000 and the weighted-average ordinary shares outstanding is 100,000?

€1.80 Signup and view all the answers

What is the effect of assuming conversion of convertible preference shares on the diluted earnings per share?

It decreases the diluted earnings per share Signup and view all the answers

What is the effect of a share dividend on the income available for ordinary shareholders?

It has no effect on the income available for ordinary shareholders Signup and view all the answers

Why is it important to consider the convertible preference shares when calculating the diluted earnings per share?

To reflect the potential dilution of earnings per share Signup and view all the answers

What is the purpose of computing the weighted-average ordinary shares outstanding in a company with multiple share issues?

To calculate the earnings per share of the company Signup and view all the answers

What is the purpose of subtracting the liability component from the fair value of convertible debt?

To calculate the equity component of the convertible debt Signup and view all the answers

What is the effect on the equity component of convertible debt when the bonds are not converted at maturity?

The equity component remains in the Share Premium—Conversion Equity account Signup and view all the answers

What is the journal entry to record the repurchase of convertible bonds before maturity?

Bonds Payable 2,000,000 / Cash 2,000,000 Signup and view all the answers

What is the reason why the market rate of interest on similar non-convertible debt is used in accounting for convertible debt?

To determine the fair value of the liability component Signup and view all the answers

What is the effect of induced conversion on the equity component of convertible debt?

The equity component is eliminated from the balance sheet Signup and view all the answers

What is the purpose of calculating the net present value of contractual future cash flows in the with-and-without approach?

To determine the fair value of the liability component Signup and view all the answers

What is the difference between the liability component and the equity component of convertible debt?

The liability component represents the contractual cash flows, while the equity component represents the residual value Signup and view all the answers

What is the purpose of accounting for convertible debt as a compound instrument?

To reflect the debt and equity components separately on the balance sheet Signup and view all the answers

What is the journal entry when the bonds are converted at maturity?

Debit Share Premium—Conversion Equity and credit Share Capital—Ordinary Signup and view all the answers

What happens to the amount originally allocated to equity when the bonds are converted before maturity?

It is transferred to the Share Premium—Ordinary account Signup and view all the answers

What is the account credited when the bonds are converted before maturity?

Share Premium—Ordinary Signup and view all the answers

What is the journal entry when the bonds are converted before maturity?

Debit Bonds Payable and credit Share Premium—Ordinary Signup and view all the answers

What is the amount transferred to the Share Premium—Ordinary account when the bonds are converted at maturity?

€194,394 Signup and view all the answers

What is the account debited when the bonds are converted at maturity?

Bonds Payable Signup and view all the answers

What is the amount credited to the Share Capital—Ordinary account when the bonds are converted at maturity?

€500,000 Signup and view all the answers

What is the total amount credited to the Share Premium accounts when the bonds are converted at maturity?

€1,694,394 Signup and view all the answers

What is the purpose of paying an additional $80,000 to the holders of its convertible debentures in the induced conversion?

To reduce the annual interest cost Signup and view all the answers

What is the journal entry to record the induced conversion?

Debit Conversion Expense, Credit Share Premium—Conversion Equity, Debit Bonds Payable, Credit Share Capital, Credit Share Premium—Ordinary, and Credit Cash Signup and view all the answers

What is the treatment of convertible preference shares in the financial statements?

Reported as part of equity Signup and view all the answers

What is the effect on equity when preference shares are converted or repurchased?

No gain or loss is recognized Signup and view all the answers

What is the purpose of the 'sweetener' in induced conversion?

To induce the conversion of debentures into shares Signup and view all the answers

What is the journal entry to record the issuance of convertible preference shares?

Debit Cash and Credit Preference Shares Signup and view all the answers

What is the effect of induced conversion on the equity component of convertible debt?

It increases the equity component Signup and view all the answers

Why do companies issue convertible debt?

To reduce the annual interest cost Signup and view all the answers

What is the primary reason corporations issue convertible debt?

To raise equity capital without giving up more ownership control Signup and view all the answers

What is the term used to describe securities that have characteristics of both debt and equity?

Hybrid securities Signup and view all the answers

What is the first step in implementing the with-and-without approach for convertible debt?

Determine the total fair value of convertible debt with both the liability and equity component Signup and view all the answers

What is the main advantage of issuing convertible debt for corporations?

To obtain debt financing at cheaper rates Signup and view all the answers

What is the journal entry to record the conversion of preference shares into ordinary shares?

Debit Share Capital—Preference, Credit Share Capital—Ordinary Signup and view all the answers

What is the purpose of the with-and-without method in accounting for convertible debt?

To allocate the total fair value of convertible debt between the liability and equity components Signup and view all the answers

If the convertible preference shares are repurchased at their fair value of €410,000, what is the journal entry?

Debit Share Capital—Preference, Credit Cash Signup and view all the answers

What is the fair value of the ordinary shares that the preference shares can be converted into?

€410,000 Signup and view all the answers

What is the characteristic of convertible bonds?

They can be converted into other corporate securities during some specified period of time Signup and view all the answers

What is the purpose of computing the net present value of contractual future cash flows in the with-and-without approach?

To determine the liability component of convertible debt Signup and view all the answers

What is the par value of each ordinary share that the preference shares can be converted into?

€2 Signup and view all the answers

Why is convertible debt accounted for as a compound instrument?

Because it has characteristics of both debt and equity Signup and view all the answers

What is the number of ordinary shares that each preference share can be converted into?

25 Signup and view all the answers

What is the total par value of the ordinary shares that the preference shares can be converted into?

€50,000 Signup and view all the answers

What is the total fair value of the ordinary shares that the preference shares can be converted into?

€410,000 Signup and view all the answers

What is the journal entry to record the repurchase of preference shares at their fair value?

Debit Share Capital—Preference, Credit Cash Signup and view all the answers

Study Notes

Features of Preference Shares

A corporation can attach preferences or restrictions to preference shares, as long as they do not violate the country's incorporation law.
Features of preference shares include cumulative, participating, convertible, callable, and redeemable.

Accounting for Preference Shares

The accounting for preference shares at issuance is similar to that for ordinary shares.
Journal entry to issue preference shares:
- Debit: Cash
- Credit: Share Capital — Preference
- Credit: Share Premium — Preference

Reacquisition of Shares

Companies purchase their outstanding shares to:
- Provide tax-efficient distributions of excess cash to shareholders
- Increase earnings per share and return on equity
- Provide shares for employee compensation contracts or to meet potential merger needs
- Thwart takeover attempts or to reduce the number of shareholders
- Make a market in the shares
Two acceptable methods for accounting for treasury shares: cost method and par (stated) value method
Treasury shares reduce equity

Purchase of Treasury Shares

Journal entry to purchase treasury shares:
- Debit: Cash
- Credit: Treasury Shares
- Credit: Share Premium — Treasury

Sale of Treasury Shares

If sold above cost, credit Retained Earnings for the difference
If sold below cost, debit Retained Earnings for the difference
Journal entries for sale of treasury shares:
- Cash
- Share Premium — Treasury
- Retained Earnings
- Treasury Shares

Retiring Treasury Shares

The decision to retire treasury shares results in their cancellation and a reduction in the number of issued shares
Retired treasury shares have the status of authorized and unissued shares

Dividend Policy

Few companies pay dividends in amounts equal to their legally available retained earnings
Reasons for not paying dividends:
- Maintain agreements with creditors
- Meet corporation requirements
- Finance growth or expansion
- Smooth out dividend payments
- Build up a cushion against possible losses

Types of Dividends

Cash dividends
Property dividends
Liquidating dividends
Share dividends
All dividends, except for share dividends, reduce the total equity in the corporation

Cash Dividends

Declared cash dividend is a liability
Companies do not declare or pay cash dividends on treasury shares
Three dates:
- Date of declaration
- Date of record
- Date of payment
Journal entries for cash dividends:
- Retained Earnings
- Dividends Payable
- Cash
- Dividends Payable

Property Dividends

Dividends payable in assets other than cash
Restate at fair value the property to be distributed, recognizing any gain or loss
Journal entries for property dividends:
- Equity Investments
- Unrealized Holding Gain or Loss — Income
- Retained Earnings
- Property Dividends Payable
- Property Dividends Payable
- Equity Investments

Liquidating Dividends

Any dividend not based on earnings reduces amounts paid-in by shareholders

Increases the number of shares outstanding
Does not decrease the par value
Increases the total par value of outstanding shares
Journal entries for share dividends:
- Ordinary Share Dividend Distributable
- Share Capital — Ordinary

To reduce the market value of shares
No entry recorded for a share split
Decrease par value and increase the number of shares

Accounting for Convertible Debt

Accounting for convertible debt involves separating the liability component and equity component.
The liability component is valued at the present value of future cash flows discounted at the market rate of interest.
The equity component is valued as the difference between the total fair value of the convertible debt and the liability component.

Issuance of Convertible Debt

Journal entry to issue convertible debt: Debit Cash, Credit Bonds Payable, and Credit Share Premium—Conversion Equity.
Example: Roche Group issues 2,000 convertible bonds with a face value of €1,000 per bond, resulting in total proceeds of €2,000,000.
The liability component is valued at €1,805,606, and the equity component is valued at €194,394.

Settlement of Convertible Bonds

Repurchase at maturity: Debit Bonds Payable and Credit Cash.
The amount originally allocated to equity remains in the Share Premium—Conversion Equity account or is transferred to the Share Premium—Ordinary account.
Repurchase before maturity: Recognize a gain or loss on the liability component and adjust the equity component.

Repurchase Before Maturity

Determine the gain or loss on the liability component.
Determine the adjustment to the equity component.
Journal entry to record repurchase before maturity: Debit Bonds Payable, Debit Share Premium—Conversion Equity, Credit Loss on Repurchase, and Credit Cash.

Induced Conversion

Issuer offers additional consideration, called a "sweetener," to induce conversion.
Sweetener is an expense of the current period.

Characteristics of Convertible Debt

Has characteristics of both debt and equity.
Can be converted into other corporate securities during some specified period of time after issuance.

Reasons for Issuing Convertible Debt

To raise equity capital without giving up more ownership control than necessary.
To obtain debt financing at cheaper rates.

Accounting for Convertible Debt Components

Convertible debt is accounted for as a compound instrument.
Companies use the "with-and-without" method to value compound instruments.
The with-and-without method involves determining the total fair value of the convertible debt and then separating the liability component and equity component.

Earnings per share (EPS) is the income earned by each ordinary share
Companies report EPS only for ordinary shares
When the income statement contains discontinued operations, companies are required to report EPS from continuing operations and net income on the face of the income statement

Simple Capital Structure

A simple capital structure consists of only ordinary shares with no potential ordinary shares upon conversion or exercise
EPS is calculated by subtracting preference share dividends from net income to arrive at income available to ordinary shareholders
EPS = (Net Income - Preference Dividends) / Weighted-Average Ordinary Shares Outstanding

Weighted-Average Ordinary Shares Outstanding

Companies must weight the shares by the fraction of the period they are outstanding
When share dividends or share splits occur, companies need to restate the shares outstanding before the share dividend or split
The weighted-average number of shares outstanding is used to calculate EPS

Share dividends and share splits can affect the weighted-average number of shares outstanding
Companies need to adjust the shares outstanding before the share dividend or split to calculate the weighted-average number of shares outstanding

Comprehensive Example

Companies need to calculate EPS using the weighted-average number of shares outstanding and income available to ordinary shareholders
Preference dividends are subtracted from net income to arrive at income available to ordinary shareholders
EPS is calculated by dividing income available to ordinary shareholders by the weighted-average number of shares outstanding

A complex capital structure exists when a corporation has convertible securities, options, warrants, or other rights that could dilute EPS
Companies report both basic and diluted EPS
Diluted EPS includes the effect of all potential dilutive ordinary shares that were outstanding during the period

If-Converted Method

The if-converted method is used to measure the dilutive effects of potential conversion on EPS
The method assumes conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period) and the elimination of related interest, net of tax

Comprehensive Example—If-Converted Method

The if-converted method is used to calculate diluted EPS
The method begins with basic EPS and adjusts for the effect of convertible securities
The adjusted net income and weighted-average ordinary shares outstanding are calculated using the if-converted method

Companies may issue convertible securities, which have characteristics of both debt and equity, making it challenging to classify them as either debt or equity.

Convertible Debt

Convertible bonds are bonds that can be converted into other corporate securities during a specified period after issuance.
Companies issue convertible debt to raise equity capital without giving up more ownership control than necessary and to obtain debt financing at cheaper rates.

Accounting for Convertible Debt

Convertible debt is accounted for as a compound instrument using the "with-and-without" method.
The process involves:
Determining the total fair value of the convertible debt with both liability and equity components.
Determining the liability component by computing the net present value of all contractual future cash flows discounted at the market rate of interest.
Subtracting the liability component from the fair value of the convertible debt to arrive at the equity component.

Example: Accounting for Convertible Debt

Roche Group issues 2,000 convertible bonds at par with a face value of €1,000 per bond, with a stated rate of interest of 6% and a market rate of interest of 9%.
The journal entry to issue the convertible debt would be:
Cash: €2,000,000
Bonds Payable: €1,805,606
Share Premium—Conversion Equity: €194,394

Settlement of Convertible Bonds

If the bonds are not converted at maturity, the company pays off the convertible debtholders.
If the bonds are converted at maturity, the equity component is transferred to the Share Premium—Ordinary account.
If the bonds are converted before maturity, the amount originally allocated to equity is transferred to the Share Premium—Ordinary account.

Induced Conversion

Induced conversion occurs when a company offers an incentive to encourage bondholders to convert their bonds.
The journal entry to record induced conversion includes a Conversion Expense and a transfer of the equity component to the Share Premium—Ordinary account.

Convertible Preference Shares

Convertible preference shares include an option for the holder to convert preference shares into a fixed number of ordinary shares.
Convertible preference shares are reported as part of equity.
When preference shares are converted or repurchased, there is no gain or loss recognized.
The journal entries to record the issuance, conversion, and repurchase of convertible preference shares involve the Share Capital and Share Premium accounts.

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This quiz covers the different features of preference shares, including cumulative, participating, convertible, callable, and redeemable shares.