Ch 16 Study Guide

Topics: Corporate finance, Stock market, Stock Pages: 11 (2947 words) Published: August 13, 2013

1.Chapter 16 examines the issues related to accounting for dilutive securities at date of issuance and at time of conversion. Also, the impact of the computation of earnings per share is presented. The significance attached to the earnings per share figure by stock-holders and potential investors has caused the accounting profession to direct a great deal of attention to the calculation and presentation of earnings per share.

Dilutive Securities

2.(S.O. 1) Dilutive securities are defined as securities that are not common stock in form but that enable their holders to obtain common stock upon exercise or conversion. The most notable examples include convertible bonds, convertible preferred stocks, warrants, and contingent shares.

Convertible Bonds

3.In the case of convertible bonds, the conversion feature allows the corporation an opportunity to obtain equity capital without giving up more ownership control than necessary. Also, the conversion feature entices the investor to accept a lower interest rate than he or she would normally accept on a straight debt issue. Accounting for convertible bonds on the date of issuance follows the procedures used to account for straight debt issues.

*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.

4.If bonds are converted into other securities, the issue price of the stock is based upon the book value of the bonds. No gain or loss is recorded as the issue price of the stock is recorded at the book value of the bonds. For example, assume that Irvine Corporation has convertible bonds with a book value of $3,200 ($3,000 plus $200 unamortized premium) convertible into 120 shares of common stock ($10 par value) with a current market value of $35 per share. The journal entry to be made is as follows:

Bonds Payable3,000
Premium on Bonds Payable200
Common Stock1,200
Paid-in Capital in Excess of Par2,000

5.When an issuer wishes to induce prompt conversion of its convertible debt to equity securities, the issuer may offer some form of additional consideration (“sweetener”). The sweetener should be reported as an expense of the current period at an amount equal to the fair value of the additional consideration given.

6.Convertible debt that is retired without exercise of the conversion feature should be accounted for as though it were a straight debt issue. Any difference between the cash acquisition price of the debt and its carrying amount should be reflected currently in income as a gain or loss.

Convertible Preferred Stock

7.(S.O. 2) Convertible preferred stock is accounted for in the same manner as non-convertible preferred stock at date of issuance. When conversion takes place, the book value method is used. Preferred Stock, along with any related Additional Paid-in Capital, is debited; Common Stock and Additional Paid-in Capital (if an excess exists) are credited. If the par value of the common stock issued exceeds the book value of the preferred stock, Retained Earnings is debited for the difference.

Stock Warrants

8.(S.O. 3) Stock warrants are certificates entitling the holder to acquire shares of stock at a certain price within a stated period. Warrants are potentially dilutive as are convertible securities. However, when stock warrants are exercised, the holder must pay a certain amount of money to obtain the shares. Also, when stock warrants are attached to debt, the debt remains after the warrants are exercised.

9.When detachable stock warrants are attached to debt, the proceeds from the sale should be allocated between the two securities. This treatment is in accordance with APB Opinion No. 14, and is based on the fact that the stock warrants can be traded separately from the debt. Allocation of the proceeds between the two securities is normally made on the basis of their fair market values at the date of issuance. The amount...
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