ch3 lecture 2022-2023.pdf

Intermediate Accounting Dilutive Securities and Earnings per Share This slide deck contains animations. Please disable animations if they cause issues with your device. Copyright ©2020 John Wile...

Intermediate Accounting Dilutive Securities and Earnings per Share This slide deck contains animations. Please disable animations if they cause issues with your device. Copyright ©2020 John Wiley & Sons, Inc.  Learning Objective 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 2 Dilutive Securities Debt and Equity Should companies report these instruments as a liability or equity? securities that have characteristics of both debt and equity. For example, a convertible bond has both debt and equity characteristics. Should a company classify this security as debt, as equity, or as part debt and part equity? LO 1 Copyright ©2020 John Wiley & Sons, Inc. 3 Convertible Debt Bonds which can be changed into other corporate securities during some specified period of time after issuance. are called convertible bonds. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 4 Reasons Corporations Issue Convertible Debt Two main reasons corporations issue convertibles: 1. To raise equity capital without giving up more ownership control than necessary. 2. Obtain debt financing at cheaper rates. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 5 Convertible Debt Components Convertible debt is accounted for as a compound instrument. Companies use the “with-and-without” method to value compound instruments. ILLUSTRATION 16.1 LO 1 Copyright ©2020 John Wiley & Sons, Inc. 6 Accounting for Convertible Debt Implementation of the with-and-without approach: 1. First, determine total fair value of convertible debt with both the liability and equity component. 2. Second, determine liability component by computing net present value of all contractual future cash flows discounted at the market rate of interest. 3. Finally, subtract liability component estimated in second step from fair value of convertible debt (issue proceeds) to arrive at the equity component. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 7 Accounting for Convertible Debt Accounting at Time of Issuance Illustration: Roche Group (CHE) issues 2,000 convertible bonds at the beginning of 2022. The bonds have a four- year term with a stated rate of interest of 6 percent and are issued at par with a face value of €1,000 per bond (the total proceeds received from issuance of the bonds are €2,000,000). Interest is payable annually at December 31. Each bond is convertible into 250 ordinary shares with a par value of €1. The market rate of interest on similar non-convertible debt is 9 percent. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 8 Accounting for Convertible Debt Liability Component and Equity Component Accounting at Time of Issuance LO 1 Copyright ©2020 John Wiley & Sons, Inc. 9 Accounting for Convertible Debt Journal Entry to Issue Convertible Debt Journal Entry Cash 2,000,000 Bonds Payable 1,805,606 Share Premium—Conversion Equity 194,394 LO 1 Copyright ©2020 John Wiley & Sons, Inc. 10 Settlement of Convertible Bonds Repurchase at Maturity If the bonds are not converted at maturity, Roche makes the following entry to pay off the convertible debtholders. Bonds Payable 2,000,000 Cash 2,000,000 NOTE: The amount originally allocated to equity of €194,384 either remains in the Share Premium—Conversion Equity account or is transferred to the Share Premium—Ordinary account. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 11 Settlement of Convertible Bonds Conversion of Bonds at Maturity If the bonds are converted at maturity, Roche makes the following entry. Share Premium—Conversion Equity 194,394 Bonds Payable 2,000,000 Share Capital—Ordinary (2000*250*1) 500,000 Share Premium—Ordinary 1,694,394 NOTE: The amount originally allocated to equity of €194,384 is transferred to the Share Premium—Ordinary account. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 12 Settlement of Convertible Bonds Conversion of Bonds Before Maturity Assume Roche converts its bonds into ordinary shares on December 31, 2023. ILLUSTRATION 16.5 LO 1 Copyright ©2020 John Wiley & Sons, Inc. 13 Conversion of Bonds Before Maturity Journal Entry on December 31, 2023 Share Premium—Conversion Equity 194,394 Bonds Payable 1,894,464 Share Capital—Ordinary 500,000 Share Premium—Ordinary 1,588,838 NOTE: There is no gain or loss on conversion before maturity: The amount originally allocated to equity (€194,374) is transferred to the Share Premium—Ordinary account. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 14 Settlement of Convertible Bonds Repurchase Before Maturity Roche determines the fair value of the liability component of the convertible bonds at December 31, 2023, and then subtracts the fair value of the convertible bond issue (including the equity component) to arrive at the value of the equity. Then, 1. The difference between the consideration allocated to the liability component and the carrying amount of the liability is recognized as a gain or loss, and 2. The amount of consideration relating to the equity component is recognized (as a reduction) in equity. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 15 Settlement of Convertible Bonds Repurchase Before Maturity (continued) 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, 2023, is €1,965,000. The fair value of the liability component is €1,904,900. This amount is based on computing the present value of a non-convertible bond with a two-year term (which corresponds to the shortened time to maturity of the repurchased bonds.) LO 1 Copyright ©2020 John Wiley & Sons, Inc. 16 Repurchase Before Maturity Gain or Loss on Liability Component and Adjustment to Equity First, determine the gain or loss on the liability component. Next, determine any adjustment to the equity. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 17 Repurchase Before Maturity Journal Entry to Record Repurchase Before Maturity Journal Entry Bonds Payable 1,894,464 Share Premium—Conversion Equity 60,100 Loss on Repurchase 10,436 Cash 1,965,000 LO 1 Copyright ©2020 John Wiley & Sons, Inc. 18 Convertible Debt Induced Conversion Issuer wishes to encourage prompt conversion. Issuer offers additional consideration, called a “sweetener,” to induce conversion. Sweetener is an expense of the current period. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 19 Induced Conversion Illustration: Helloid, Inc. has outstanding $1,000,000 par value convertible debentures convertible into 100,000 ordinary shares ($1 par value). When issued, Helloid recorded Share Premium—Conversions Equity of $15,000. Helloid wishes to reduce its annual interest cost. To do so, Helloid agrees to pay the holders of its convertible debentures an additional $80,000 if they will convert. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 20 Induced Conversion Journal Entry to Record Induced Conversion Conversion Expense 80,000 Share Premium—Conversion Equity 15,000 Bonds Payable 1,000,000 Share Capital —Ordinary 100,000 Share Premium—Ordinary 915,000 Cash 80,000 LO 1 Copyright ©2020 John Wiley & Sons, Inc. 21 Convertible Preference Shares Convertible preference shares include an option for the holder to convert preference shares into a fixed number of ordinary shares. Convertible preference shares are reported as part of equity. When preference shares are converted or repurchased, there is no gain or loss recognized. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 22 Convertible Preference Shares Journal Entry to Record Issuance of Shares Illustration: Morse AG issues 1,000 convertible preference shares that have a par value of €1 per share. The shares were issued at a price of €200 per share. The journal entry to record this transaction is as follows. Cash (1,000 × €200) 200,000 Share Capital—Preference (1,000 × 1,000 €1) Share Premium—Conversion Equity 199,000 LO 1 Copyright ©2020 John Wiley & Sons, Inc. 23 Convertible Preference Shares Journal Entry to Record Conversion of Preference Shares into Ordinary Shares Illustration: If each share is subsequently converted into 25 each ordinary shares (€2 par value) that have a fair value of €410,000, the journal entry to record the conversion is as follows. Share Capital—Preference 1,000 Share Premium—Conversion Equity 199,000 Share Capital—Ordinary (1,000 × 25× €2) 50,000 Share Premium—Ordinary 150,000 LO 1 Copyright ©2020 John Wiley & Sons, Inc. 24 Convertible Preference Shares Journal Entry to Record Repurchase of Preference Shares Illustration: If the convertible preference shares are repurchased at their fair value of €410,000 instead of converted, Morse makes the following entry. Share Capital—Preference 1,000 Share Premium—Conversion Equity 199,000 Retained Earnings 210,000 Cash 410,000 Any excess paid above the book value of the convertible preference shares is often debited to Retained Earnings. LO 1 Copyright ©2020 John Wiley & Sons, Inc. 25  Learning Objective 3 Describe the accounting and reporting for share compensation plans. LO 3 Copyright ©2020 John Wiley & Sons, Inc. 26 Share Compensation Plans Share Option - gives key employees option to purchase ordinary shares at a given price over extended period of time. Effective compensation programs are ones that: 1. Base compensation on performance. 2. Motivate employees. 3. Help retain executives and recruit new talent. 4. Maximize employee’s after-tax benefit and minimize employer’s after-tax cost. 5. Use performance criteria over which employee has control. LO 3 Copyright ©2020 John Wiley & Sons, Inc. 27