CONCEPTS
FOR ANALYSIS
CA16-1 (Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.
Instructions
(a) (1) Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.
(2) Discuss the underlying rationale for the differences described in (a)(1) above.
(3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants.
(b) At the start of the year, Huish Company issued $18,000,000 of 12% bonds along with detachable warrants to buy 1,200,000 shares of its $10 par value common stock at $18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of $1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have sold in the market at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received. (AICPA adapted)
CA16-2 ETHICS (Ethical Issues—Compensation Plan) The executive officers of Rouse Corporation have a performance-based compensation plan. The performance criteria of this plan is linked to growth in earnings per share. When annual EPS growth is 12%, the Rouse executives earn 100% of the shares; if growth is 16%, they earn 125%. If EPS growth is lower than 8%, the executives receive no additional compensation.
In 2014, Joan Devers, the controller of Rouse, reviews year-end estimates of bad debt expense and warranty expense. She calculates the EPS growth at 15%. Kurt Adkins, a member of the executive group, remarks over lunch one day that the estimate of bad debt expense might be decreased, increasing EPS growth to 16.1%. Devers is not sure she should do this because she believes that the current estimate of bad debts is sound. On the other hand, she recognizes that a great deal of subjectivity is involved in the computation.
Instructions
Answer the following questions.
(a) What, if any, is the ethical dilemma for Devers?
(b) Should Devers’s knowledge of the compensation plan be a factor that influences her estimate?
(c) How should Devers respond to Adkins’s request?
CA16-3 WRITING (Stock Warrants—Various Types) For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued:
1. To existing stockholders on a pro rata basis.
2. To certain key employees under an incentive stock-option plan.
3. To purchasers of the corporation’s bonds.
Instructions
For each of the three examples of how stock warrants are used:
(a) Explain why they are used.
(b) Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company’s stock, and (2) the length of time over which they can be exercised.
(c) Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above.
(AICPA adapted)
CA16-4 WRITING (Stock Compensation Plans) The following two items appeared on the Internet concerning the GAAP requirement to expense stock options…
Instructions
(a) What are the major recommendations of the stock-based compensation pronouncement?
(b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.)
(c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.
CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) “Earnings per share” (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a “times earnings” figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.
Instructions
(a) Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS.
(b) One of the technical procedures applicable in EPS computations is the “treasury-stock method.” Briefly describe the circumstances under which it might be appropriate to apply the treasury-stock method.
(c) Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations.
(AICPA adapted)
CA16-6 WRITING (EPS, Antidilution) Brad Dolan, a stockholder of Rhode Corporation, has asked you, the firm’s accountant, to explain why his stock warrants were not included in diluted EPS. In order to explain this situation, you must briefly explain what dilutive securities are, why they are included in the EPS calculation, and why some securities are antidilutive and thus not included in this calculation.
Rhode Corporation earned $228,000 during the period, when it had an average of 100,000 shares of common stock outstanding.
The common stock sold at an average market price of $25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant.
Instructions
Write Mr. Dolan a 1–1.5-page letter explaining why the warrants are not included in the calculation.
CA16-1 (Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.
Instructions
(a) (1) Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.
(2) Discuss the underlying rationale for the differences described in (a)(1) above.
(3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants.
(b) At the start of the year, Huish Company issued $18,000,000 of 12% bonds along with detachable warrants to buy 1,200,000 shares of its $10 par value common stock at $18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of $1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have sold in the market at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received. (AICPA adapted)
CA16-2 ETHICS (Ethical Issues—Compensation Plan) The executive officers of Rouse Corporation have a performance-based compensation plan. The performance criteria of this plan is linked to growth in earnings per share. When annual EPS growth is 12%, the Rouse executives earn 100% of the shares; if growth is 16%, they earn 125%. If EPS growth is lower than 8%, the executives receive no additional compensation.
In 2014, Joan Devers, the controller of Rouse, reviews year-end estimates of bad debt expense and warranty expense. She calculates the EPS growth at 15%. Kurt Adkins, a member of the executive group, remarks over lunch one day that the estimate of bad debt expense might be decreased, increasing EPS growth to 16.1%. Devers is not sure she should do this because she believes that the current estimate of bad debts is sound. On the other hand, she recognizes that a great deal of subjectivity is involved in the computation.
Instructions
Answer the following questions.
(a) What, if any, is the ethical dilemma for Devers?
(b) Should Devers’s knowledge of the compensation plan be a factor that influences her estimate?
(c) How should Devers respond to Adkins’s request?
CA16-3 WRITING (Stock Warrants—Various Types) For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued:
1. To existing stockholders on a pro rata basis.
2. To certain key employees under an incentive stock-option plan.
3. To purchasers of the corporation’s bonds.
Instructions
For each of the three examples of how stock warrants are used:
(a) Explain why they are used.
(b) Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company’s stock, and (2) the length of time over which they can be exercised.
(c) Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above.
(AICPA adapted)
CA16-4 WRITING (Stock Compensation Plans) The following two items appeared on the Internet concerning the GAAP requirement to expense stock options…
Instructions
(a) What are the major recommendations of the stock-based compensation pronouncement?
(b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.)
(c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.
CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) “Earnings per share” (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a “times earnings” figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.
Instructions
(a) Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS.
(b) One of the technical procedures applicable in EPS computations is the “treasury-stock method.” Briefly describe the circumstances under which it might be appropriate to apply the treasury-stock method.
(c) Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations.
(AICPA adapted)
CA16-6 WRITING (EPS, Antidilution) Brad Dolan, a stockholder of Rhode Corporation, has asked you, the firm’s accountant, to explain why his stock warrants were not included in diluted EPS. In order to explain this situation, you must briefly explain what dilutive securities are, why they are included in the EPS calculation, and why some securities are antidilutive and thus not included in this calculation.
Rhode Corporation earned $228,000 during the period, when it had an average of 100,000 shares of common stock outstanding.
The common stock sold at an average market price of $25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant.
Instructions
Write Mr. Dolan a 1–1.5-page letter explaining why the warrants are not included in the calculation.
