Chapter 16 – Dilutive Securities ACTG 6580 Chapter 16 – Dilutive Securities

DILUTIVE SECURITIES AND COMPENSATION PLANS Debt and Equity Should companies report these instruments as a liability or equity? Share Options Convertible Securities Preference Shares LO 1

Distinguishing Financial Liabilities From Equity Instruments Debt/equity distinctions are important – affects leverage and solvency ratios, debt covenants, treatment of payments as either interest or dividends & capital adequacy requirements A ‘substance over form’ test aims to limit attraction to misclassify many as equity instruments (when they essentially should be classified as liabilities)

Distinguishing Financial Liabilities From Equity Instruments – Substance Over Form Test Equity instruments need to meet two conditions (A & B) Part A - An equity instrument must include no contractual obligation to: Deliver financial assets to another entity Exchange assets/liabilities unfavorable to the issuer Part B – The instrument will or may be settled in the issuer’s own equity instruments

Debt versus Equity IFRS US GAAP Instruments that require settlement with a variable number of shares establish a debtor/creditor relationship and are thus are treated as liabilities. This is true even if the legal form is preferred stock. Those that require settlement with a fixed number of shares generally establish more of a shareholder relationship and are thus treated as equity. US GAAP IFRS Similar.

Classification, Recognition and Measurement Classification of debt versus equity US GAAP Classification is addressed on an instrument-by-instrument basis: The legal form often dictates the classification . ASC 480 requires that specific instruments be classified as liabilities, even if they are stock and even if they have characteristics of both debt and equity. Some examples of instruments that must be accounted for as debt include: Mandatorily redeemable shares. Instruments that must be redeemed or repaid using a variable number of the entity’s shares. Instruments requiring an entity to repurchase its own stock for cash or other assets. IFRS Classification starts with the definitions. The focus is on whether there is a contractual obligation to deliver cash, other assets or a variable number of the entity’s own shares. If such an obligation exists, a liability exists. This is applied to all instruments whether they are loans/bonds or preferred or common stock. Unless the entity has an unconditional right to avoid delivering cash or other financial assets, it is a liability.

Convertible Debt Bonds which can be changed into other corporate securities are called convertible bonds. Benefit of a Bond (guaranteed interest and principal) + Privilege of Exchanging it for Shares (at the holder’s option) LO 1

Convertible Debt Two main reasons corporations issue convertibles: To raise equity capital without giving up more ownership control than necessary. Obtain debt financing at cheaper rates. LO 1

Convertible Debt Accounting for Convertible Debt Convertible debt is accounted for as a compound instrument. Companies use the “with-and-without” method to value compound instruments. ILLUSTRATION 16-1 Convertible Debt Components LO 1

Convertible Debt Accounting for Convertible Debt Implementation of the with-and-without approach: First, determine total fair value of convertible debt with both the liability and equity component. Second, determine liability component by computing net present value of all contractual future cash flows discounted at the market rate of interest. Finally, subtract liability component estimated in second step from fair value of convertible debt (issue proceeds) to arrive at the equity component. LO 1

Convertible Debt Accounting at Time of Issuance Illustration: Roche Group (CHE) issues 2,000 convertible bonds at the beginning of 2015. 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

Convertible Debt Accounting at Time of Issuance LO 1 ILLUSTRATION 16-2 Time Diagram for Convertible Bond Accounting at Time of Issuance ILLUSTRATION 16-3 Fair Value of Liability Component of Convertible Bond ILLUSTRATION 16-4 Equity Component of Convertible Bond LO 1

Convertible Debt Accounting at Time of Issuance Cash 2,000,000 ILLUSTRATION 16-3 Fair Value of Liability Component of Convertible Bond ILLUSTRATION 16-4 Equity Component of Convertible Bond Cash 2,000,000 Bonds Payable 1,805,626 Share Premium—Conversion Equity 194,374 Journal Entry LO 1

Convertible Debt 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 €194,374 either remains in the Share Premium—Conversion Equity account or is transferred to the Share Premium—Ordinary account. LO 1

Convertible Debt 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 194,374 Bonds Payable 2,000,000 Share Capital—Ordinary 500,000 Share Premium—Ordinary 1,694,374 NOTE: The amount originally allocated to equity of €194,374 is transferred to the Share Premium—Ordinary account. LO 1

Convertible Debt Settlement of Convertible Bonds Conversion of Bonds before Maturity. ILLUSTRATION 16-5 Convertible Bond Amortization Schedule LO 1

Convertible Debt Settlement of Convertible Bonds Conversion of Bonds before Maturity. Assuming that Roche converts its bonds into ordinary shares on December 31, 2016. Share Premium—Conversion Equity 194,374 Bonds Payable 1,894,464 Share Capital—Ordinary 500,000 Share Premium—Ordinary 1,588,838 NOTE: The amount originally allocated to equity (€194,374) is transferred to the Share Premium—Ordinary account. LO 1

Convertible Debt Settlement of Convertible Bonds Repurchase before Maturity. Roche determines the fair value of the liability component of the convertible bonds at December 31, 2016, and then subtracts the fair value of the convertible bond issue (including the equity component) to arrive at the value of the equity. Then, 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 The amount of consideration relating to the equity component is recognized (as a reduction) in equity. LO 1

Convertible Debt Settlement of Convertible Bonds Repurchase before Maturity. Assume: Fair value of the convertible debt (including both liability and equity components), based on market prices at December 31, 2016, 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

Convertible Debt Settlement of Convertible Bonds First, determine the gain or loss on the liability component. ILLUSTRATION 16-6 Next, determine any adjustment to the equity. ILLUSTRATION 16-7 LO 1

Convertible Debt Settlement of Convertible Bonds ILLUSTRATION 16-6 & 7 Bonds Payable 1,894,464 Share Premium—Conversion Equity 60,100 Loss on Repurchase 10,436 Cash 1,965,000 Journal Entry LO 1

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 2

Convertible Preference Shares Illustration: Morse Company 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 x €200) 200,000 Share Capital—Preference (1,000 x €1) 1,000 Share Premium—Conversion Equity 199,000 LO 2

Convertible Preference 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 x 25 x €2) 50,000 Share Premium—Ordinary 150,000 LO 2

Convertible Preference Shares Illustration: If the convertible preference shares are repurchased at their fair value 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 2

Mandatorily Redeemable Preferred Stock Must be treated as a liability because There is an obligation to redeem the preferred shares The entity does not have an unconditional right to avoid delivering cash or other financial assets, so it is a liability. Dividends would be treated as interest expense.

GLOBAL ACCOUNTING INSIGHTS DILUTIVE SECURITIES AND EARNINGS PER SHARE Both the FASB and the IASB are working on a standard related to the distinction between liabilities and equity. The U.S. GAAP approach to account for certain dilutive securities, such as convertible debt and debt issued with share warrants, is different than IFRS. The accounting and disclosure requirements for accounting for share options and EPS computations are similar between U.S. GAAP and IFRS.

GLOBAL ACCOUNTING INSIGHTS Relevant Facts Differences Under U.S. GAAP, all of the proceeds of convertible debt are recorded as long-term debt. Under IFRS, convertible bonds are “bifurcated”—separated into the equity component (the value of the conversion option) of the bond issue and the debt component.

GLOBAL ACCOUNTING INSIGHTS On the Horizon The FASB has been working on a standard that will likely converge to IFRS in the accounting for convertible debt. Similar to the IASB, the FASB is examining the classification of hybrid securities; the IASB is seeking comment on a discussion document similar to the FASB Preliminary Views document, “Financial Instruments with Characteristics of Equity.” It is hoped that the Boards will develop a converged standard in this area.

Homework E16-1, E16-2, E16-3 DUE THURSDAY, OCTOBER 29