Chapter 16 Dilutive Securities

In 2014, Chartres Inc., issued for $105 per share, 60,000 shares of $100 par value convertible preferred stock. One share of preferred stock can be converted into three shares of Chartre's $25 par value common stock at the option of the preferred stockholder. In April 2015, all of the preferred stock was converted into common stock. The market value of the common stock at the date of the conversion was $30 per share. What total amount should be credited to additional paid-in capital from common stock as a result of the conversion of the preferred stock into common stock?

$1,800,000 The preferred stock's par value and any additional paid-in capital is transferred to Common Stock and Additional Paid-in Capital when preferred stock is converted: $6,300,000 - (60,000 × 3 × $25) = $1,800,000.

Lake Norman Corporation offered detachable 5-year warrants to buy one share of common stock (par value $5) at $20 (at a time when the stock was selling for $32). The price paid for 2,000, $1,000 bonds with the warrants attached was $205,000. The market price of the Lake Norman bonds without the warrants was $180,000, and the market price of the warrants without the bonds was $20,000. What amount should be allocated to the warrants?

$20,500 The amount allocated to the warrants is: [$20,000 ÷ ($20,000 + $180,000)] × $205,000 = $20,500.

On January 1, 2014, Korsak, Inc. established a stock appreciation rights plan for its executives. It entitled them to receive cash at any time during the next four years for the difference between the market price of its common stock and a pre-established price of $20 on 100,000 SARs. Current market prices of the stock are as follows: January 1, 2014 $35 per share December 31, 2014 38 per share December 31, 2015 30 per share December 31, 2016 33 per share Compensation expense relating to the plan is to be recorded over a four-year period beginning January 1, 2014.What amount of compensation expense should Korsak recognize for the year ended December 31, 2014?

$450,000

On December 1, 2014, Lester Company issued at 103, five hundred of its 9%, $1,000 bonds. Attached to each bond was one detachable stock warrant entitling the holder to purchase 10 shares of Lester's common stock. On December 1, 2014, the market value of the bonds, without the stock warrants, was 95, and the market value of each stock purchase warrant was $50. The amount of the proceeds from the issuance that should be accounted for as the initial carrying value of the bonds payable would be

$489,250

On May 1, 2014, Marly Co. issued $1,500,000 of 7% bonds at 103, which are due on April 30, 2024. Twenty detachable stock warrants entitling the holder to purchase for $40 one share of Marly's common stock, $15 par value, were attached to each $1,000 bond. The bonds without the warrants would sell at 96. On May 1, 2014, the fair value of Marly's common stock was $35 per share and of the warrants was $2.On May 1, 2014, Marly should credit Paid-in Capital from Stock Warrants for

$61,800

On January 1, 2014, Western Carolina Company granted Andy Eggers, an employee, an option to buy 2,000 shares of Western Carolina Co. stock for $25 per share, the option exercisable for 5 years from date of grant. Using a fair value option pricing model, total compensation expense is determined to be $21,000. Eggers exercised his option on September 1, 2014, and sold his 2,000 shares on December 1, 2014. Quoted market prices of Western Carolina Co. stock during 2014 were January 1$25 per share September 1$30 per share December 1$34 per share The service period is for three years beginning January 1, 2014. As a result of the option granted to Eggers, using the fair value method, Western Carolina should recognize compensation expense for 2014 on its books in the amount of

$7,000 The compensation expense of $21,000 over the three year service period results in an annual expense of $7,000.

When $5,000,000 in convertible bonds are issued at par with $800,000 in value of the equity option embedded in the bond, the IFRS journal entry will include a debit of A) $800,000 to Bonds Payable and a credit to Paid-in Capital — Convertible Bonds. B) $800,000 to Premium on Bonds Payable and a credit to Paid-in Capital — Convertible Bonds. C) $4,200,000 to Cash along with a debit of $800,000 to Discount on Bonds Payable and a credit to Bonds Payable and a credit to Paid-in Capital — Convertible Bonds. D) $800,000 to Paid-in Capital — Convertible Bonds and a credit to Bonds Payable.

$800,000 to Bonds Payable and a credit to Paid-in Capital — Convertible Bonds.

Retirement of Convertible Debt

- Recognized same as retiring debt that is not convertible. - Difference between the cash acquisition price and carrying amount should be reported as gain or loss in the income statement.

nondetachable warrants

-Do not require an allocation of proceeds between the bonds and the warrants -Companies record the entire proceeds as debt

Induced Conversion

-Issuer wishes to encourage prompt conversion. -Issuer offers additional consideration, called "sweetener" -Sweetener is an expense on the current period.

Complex Capital Structure exists when a business has

-convertible securities -options, warrants, or other rights that upon conversion or exercise could dilute earnings per share Company generally reports both basic and diluted earnings per share.

Employee Stock-Purchase Plans

-generally permit all employees to purchase stock at a discounted price for a short period of time Plans are considered compensatory unless they satisfy all three conditions present below 1. Substantially all full-time employees may participate on an equitable basis 2. The discount from market is small 3. The plan offers no substantive option feature.

Tow 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 The accounting for convertible debt involves reporting issues at the time of (1) issuance, (2) conversion, and (3) retirement

Measuring the dilutive effects of potential conversion on EPS using the if-converted method assumes:

1. the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and 2. the elimination of related interest, net of tax

Measuring the dilutive effects of potential conversion on EPS using the treasury-stock method assumes:

1. the exercise the options or warrants at the beginning of the year (or date of issue if later), and 2. that the company uses those proceeds to purchase common stock for the treasury

At December 31, 2014, Twin Rivers Company had 450,000 shares of common stock issued and outstanding, 350,000 of which had been issued and outstanding throughout the year and 100,000 of which were issued on September 1, 2014. Net income for the year ended December 31, 2014, was $1,160,000. What should be Twin Rivers' 2014 earnings per common share, rounded to the nearest penny?

3.03 $1,160,000/[350,000 + (100,000 × 4/12) = $3.03

Which of the following is correct about the effective-interest method of amortization? A) The effective-interest method produces a constant rate of return on the book value of the investment from period to period. B) Amortization of a premium decreases from period to period. C) The effective-interest method applied to investments in debt securities is different from that applied to bonds payable. D) Amortization of a discount decreases from period to period.

A) The effective-interest method produces a constant rate of return on the book value of the investment from period to period.

When investments in debt securities are purchased between interest payment dates, preferably the A) accrued interest is debited to Interest Revenue. B) securities account should include accrued interest. C) accrued interest is debited to Interest Receivable. D) accrued interest is debited to Interest Expense.

A) accrued interest is debited to Interest Revenue.

Compensation expense resulting from a compensatory stock option plan is generally A) allocated to the periods benefited by the employee's required service. B) recognized in the period of exercise. C) allocated over the periods of the employee's service life to retirement. D) recognized in the period of the grant.

A) allocated to the periods benefited by the employee's required service.

For stock appreciation rights, share appreciation is the excess of the market price of the stock at the date ______ over a pre-established price. A) of exercise. B) the rights mature. C) of grant. D) the stock's price reaches a predetermined amount.

A) of exercise.

Pesca Company had 820,000 shares of common stock outstanding on January 1, issued 360,000 shares on April 1 and purchased 24,000 shares of treasury stock on December 1. The weighted average shares outstanding for the year is A) 888,000. B) 1,088,000. C) 1,178,000. D) 1,156,000.

B) 1,088,000. The weighted average shares outstanding for the year is:820,000 + (360,000 × 9/12) - (24,000 × 1/12) = 1,088,000

With regard to recognizing stock-based compensation A) It has been agreed that these standards will not be merged due to the differences in currencies. B) IFRS and U.S. GAAP follow the same model. C) IFRS and U.S. GAAP standards are undergoing major reform on valuation issues. D) The reform of U.S. GAAP standards will not be addressed until IFRS standards have been finalized.

B) IFRS and U.S. GAAP follow the same model.

All of the following statements are the key similarities and differences between GAAP and IFRS related to dilutive securities and earnings per share, except: A) 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. B) The calculation of basic and diluted earnings per share is completely different between IFRS and GAAP. C) Modification of a share option results in the recognition of any incremental fair value under both IFRS and GAAP. However, if the modification leads to a reduction, IFRS does not permit the reduction but GAAP does. D) A significant difference in IFRS and U.S. GAAP exists with respect to the accounting for convertible debt.

B) The calculation of basic and diluted earnings per share is completely different between IFRS and GAAP.

The proceeds from the sale of debt with detachable stock warrants should be allocated between the two securities based on the: A) ace value of the bonds. B) aggregate fair market value of the bonds and the warrants. C) face value of the bonds and market value of the warrants. D) fair market value of the bonds.

B) aggregate fair market value of the bonds and the warrants.

An available-for-sale debt security is purchased at a discount. The entry to record the amortization of the discount includes a A) debit to Interest Revenue. B) debit to Debt Investments. C) none of these answers are correct. D) debit to the discount account.

B) debit to Debt Investments.

An executive pays no taxes at the time of exercise in a(an) A) stock appreciation rights plan. B) incentive stock option plan. C) taxes would be paid in all of these. D) nonqualified stock option plan.

B) incentive stock option plan.

stock warrants issued with other securities

Basically long-term options to buy common stock at a fixed price. -Generally life of warrants is five years, occasionally ten years -Proceeds allocated between the two securities -Allocation based on fair market values -Two methods of allocation: 1. Proportional method 2. Incremental method

Under IFRS, what is recorded as compensation expense for all employee share-purchase plans? A) Par value of shares B) Amount paid by employees C) Amount of discount D) Amount transferred to share premium

C) Amount of discount

In the diluted earnings per share computation, the treasury stock method is used for options and warrants to reflect assumed reacquisition of common stock at the average market price during the period. If the exercise price of the options or warrants exceeds the average market price, the computation would A) reflect the excess of the number of shares assumed issued over the number of shares assumed reacquired as the potential dilution of earnings per share. B) fairly present the maximum potential dilution of diluted earnings per share on a prospective basis. C) be antidilutive. D) fairly present diluted earnings per share on a prospective basis.

C) be antidilutive. If the exercise price of the options or warrants exceeds the average market price, the computation would be antidilutive.

APB Opinion No. 21 specifies that, regarding the amortization of a premium or discount on a debt security, the A) effective-interest method of allocation must be used. B) straight-line method of allocation must be used. C) effective-interest method of allocation should be used but other methods can be applied if there is no material difference in the results obtained. D) par value method must be used and therefore no allocation is necessary.

C) effective-interest method of allocation should be used but other methods can be applied if there is no material difference in the results obtained.

A company estimates the fair value of SARs, using an option-pricing model, for A) both equity awards and liability awards. B) neither equity awards or liability awards. C) share-based liability awards. D) share-based equity awards.

C) share-based liability awards.

Earnings per Share - Simple Structure

Common stock; no potentially dilutive securities.

Weighted-Average Number of Shares Outstanding

Companies must weight the shares by the fraction of the period they are outstanding. When stock dividends or share splits occur, companies need to restate the shares outstanding before the share dividend or split.

Accounting for Convertible Debt - At Time of Conversion

Companies use the book value method when converting bonds. When the debtholder converts the debt to equity, the issuing company recognizes no gain or loss upon conversion.

Disclosure of Compensation Plans

Company with one or more share-based payment arrangements Must disclose: 1.nature and extent of such arrangements. 2.effect on the income statement of compensation cost. 3.method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant). 4. cash flow effects.

Under IFRS, how are convertible debt recorded? A) Convertible debt is added to current liability section, as it will be converted to equity. B) Convertible debt is recorded under stockholders' equity. C) Convertible debt is recorded as long-term liability. D) Convertible debt is separated into equity component and debt component.

D) Convertible debt is separated into equity component and debt component.

Which of the following is not generally correct about recording a sale of a debt security before maturity date? A) An entry must be made to amortize a discount to the date of sale. B) A gain or loss on the sale is not extraordinary. C) Accrued interest will be received by the seller even though it is not an interest payment date. D) The entry to amortize a premium to the date of sale includes a credit to the Premium on Investments in Debt Securities.

D) The entry to amortize a premium to the date of sale includes a credit to the Premium on Investments in Debt Securities.

Dilutive convertible securities must be used in the computation of A) diluted and basic earnings per share. B) none of these answer choices is correct. C) basic earnings per share only. D) diluted earnings per share only.

D) diluted earnings per share only. Dilutive convertible securities must be used in the computation of diluted earnings per share only.

In computing earnings per share for a simple capital structure, if the preferred stock is cumulative, the amount that should be deducted as an adjustment to the numerator (earnings) is the A) preferred dividends in arrears. B) preferred dividends in arrears times (one minus the income tax rate). C) annual preferred dividend times (one minus the income tax rate). D) none of these answer choices is correct.

D) none of these answer choices is correct. In a simple capital structure an amount equal to the dividend that should have been declared for the current year only is subtracted from net income.

Moore Corporation has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. The bonds converted on December 31, 2017, when the unamortized discount is $30,000 and the market price of the stock is $21 per share. Prepare the entry to record the conversion of the bonds.

DR Bonds Payable 2,000,000 CR Discount on Bonds Payable 30,000 CR Common Stock 1,000,000 CR Paid-in Capital in Excess of Par-Common 970,000

Margolf Corp. 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 value of $40. Use the incremental method to record the issuance of the bonds and warrants.

DR Cash 2,020,000 DR Discount on Bonds Payable 40,000 CR Bonds Payable 2,000,000 CR Paid-in Capital - Stock Warrants 60,000

Margolf Corp. 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 value of $40. Use the proportional method to record the issuance of the bonds and warrants.

DR Cash 2,020,000 DR Discount on Bonds Payable 59,216 CR Bonds Payable 2,000,000 CR Paid-in Capital - Stock Warrants

Miller Corporation 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. Record the entry at date of issuance.

DR Cash 3,960,000 DR Discount on Bonds Payable 40,000 CR Bonds Payable 4,000,000

Moore Corporation has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. Assume Moore wanted to reduce its annual interest cost and agreed to pay the bondholders $70,000 to convert.

DR Debt Conversion Expense 70,000 CR Cash 70,000

Gall Inc. 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. Prepare the entry to record the conversion.

DR Preferred Stock 50,000 DR Paid-in Capital in Excess of Par - Preferred 10,000 CR Common Stock (2,000 x $10) 20,000 CR Paid-in Capital in Excess of Par - Common 40,000

Stock Option

Gives key employees the option to purchase common stock at a given price over an 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 5. Use performance criteria over which employee has control

With regard to contracts that can be settled in either cash or shares A) The FASB project proposes that the IASB adopt the U.S. GAAP approach, requiring that share settlement must be used. B) IFRS gives companies a choice of either cash or shares. C) U.S. GAAP requires that share settlement must be used. D) IFRS requires that share settlement must be used.

IFRS requires that share settlement must be used.

Earnings per Share - Complex Structure

Includes securities that could dilute earnings per common share

Earnings Per Share Formula

Is the ratio that evaluates the operating performance and profitability of a company. EPS = (Net Income - Preferred Dividends)/ Average number of shares of common stock outstanding during the period

What will the numerator of the diluted EPS calculation consist of when convertible preferred stock is being included? A) Net income - Preferred dividends. B) Net income + Preferred dividends. C) Net income + Preferred dividends (Net of tax effect). D) Net income.

Net Income Only net income because it is assumed that the convertible preferred shares have been converted and are outstanding as common shares.

Accounting for Convertible Debt - At Time of Issuance

Recording convertible bonds follows the method used to record straight debt issues, with any discount or premium over the term of the debt.

Which of the following is not a characteristic of a noncompensatory stock option plan? A) Discount from the market price of the stock no greater than would be reasonable in an offer of stock to stockholders or others. B) The plan offers no substantive option feature. C) Substantially all full-time employees may participate on an equitable basis. D) Unlimited time period permitted for exercise of an option as long as the holder is still employed by the company.

Unlimited time period permitted for exercise of an option as long as the holder is still employed by the company.

Incremental Method

When a company cannot determine the fair value of either the warrants or the bonds, the company uses the security for which it can determine the fair value, and allocates the remainder of the purchase price to the security for which it does not know the fair value.

Detachable warrants involves two securities:

a debt security and a warrant to purchase common stock

Proportional Method

allocates the proceeds using the proportion of the two amounts, based on fair values Determine: 1. value of the bonds without the warrants, and 2. value of the warrants

Stock Warrants

are certificates entitling the holder to acquire shares of stock at a certain price within a stated period. Normally arises under three situations: 1. To make the security more attractive 2. Existing stockholders have a preemptive right to purchase common stock first 3. To executives and employees as a form of compensation

Convertible bonds

can be changed into other corporate securities during some specified period of time after issuance It has the benefit of the bond (guaranteed interest and principal) and privilege of exchanging it for stock (at the holder's option)

Convertible bonds are usually converted into:

common stock Convertible bonds are usually convertible into a specified number of common shares.

When a bond issuer offers some form of additional consideration (a "sweetener") to induce conversion, the sweetener is accounted for as a(n)

expense

Convertible preferred stock

includes an option for the holder to convert preferred shares into a fixed number of common shares - Classified as part of stockholders' equity, unless mandatory redemption exists. -No theoretical justification for recognizing a gain or loss when exercised.

Diluted EPS

includes the effect of all potential dilutive common shares that were outstanding during the period -Companies will not report diluted EPS if the securities in their capital structure are antidilutive.

Earnings per share

indicates the income earned by each share of common stock -companies report earnings per share only for common stock -when the income statement contains intermediate components, such as discontinued operations, companies should disclose earnings per share for each component

The date on which to measure the compensation element in a stock option granted to a corporate employee ordinarily is the date on which the employee A) may first exercise the option. B) exercises the option. C) is granted the option. D) has performed all conditions precedent to exercising the option.

is granted the option.

Earnings per Share - "Dilutive"

the ability to influence the EPS in a downward direction

Proceeds from an issue of debt securities having stock warrants should not be allocated between debt and equity features when

the warrants issued with the debt securities are nondetachable.

The conversion of preferred stock into common requires that any excess of the par value of the common shares issued over the carrying amount of the preferred being converted should be

treated as a direct reduction of retained earnings When preferred stock is converted to common, any excess of the par value of the common shares issued over the carrying amount of the preferred being converted reduced retained earnings.