Chapter 16

Question 1

Why do companies want to issue convertible bonds?

Answer 1

To raise capital and have lower interest payments (lower interest rates), more attractive to investors

Question 2

What is the accounting entry for the issuance of convertible bonds?

Answer 2

Debit cash, credit bonds payable, parallels accounting for straight debt

Question 3

What is a convertible bond?

Answer 3

Hybrid financial instrument composed of debt and equity

Question 4

What does it mean to bifurcate a bond?

Answer 4

cut the instrument into two portions (debt and equity)

Question 5

How are convertible bonds treated in international standards?

Answer 5

Always bifurcated

Question 6

What happens at conversion of convertible bonds?

Answer 6

Book value of bonds is removed and replaced with common stock, discount and premiums also removed

Question 7

Who initiates the conversion of convertible bonds?

Answer 7

the security holder

Question 8

What type of expense are induced conversions?

Answer 8

period expenses

Question 9

What are stock warrants/options?

Answer 9

Entitle the holder to acquire additional common stock within a stipulated period at a specified period

Question 10

What effect do stock warrants have on EPS?

Answer 10

a dilutive effect

Question 11

What happens upon exercise of a stock warrant?

Answer 11

cash is received by the issuer

Question 12

In what ways can stock warrants be issued?

Answer 12

independently or with another security

Question 13

What are the types of stock warrants issued with other securities?

Answer 13

detachable and non-detachable

Question 14

How are detachable warrants treated?

Answer 14

bifurcated because they exist separately

Question 15

How are nondetachable warrants treated?

Answer 15

treated like convertible bonds, cannot be bifurcated because they cannot exist seperately

Question 16

What methods are used to determine the value of a detachable warrant?

Answer 16

proportional method and incremental method

Question 17

What method is used if the warrant is nondetachable?

Answer 17

no allocation to warrants is made

Question 18

When is the proportional method used?

Answer 18

When both the FMV of the bonds and warrants are known

Question 19

When is the incremental method used?

Answer 19

When only one of the FMV of the bonds or warrants are known

Question 20

Proportional Method of Allocation

Answer 20

(FMV of bonds or warrants/Total FMV of bonds and warrants) x par value/issuance price

Question 21

Incremental Method of Allocation

Answer 21

total receipt (par value) - known FMV of bonds or warrants = FMV of unknown

Question 22

What is the purpose of stock compensation plans?

Answer 22

to provide employees incentives that align with shareholders, provide motivation

Question 23

What are types of stock compensation plans?

Answer 23

stock option plans, stock appreciation plans, and performance plans

Question 24

How is the value of compensation determined?

Answer 24

The Black Scholes Model

Question 25

What is the result of the intrinsic method of measuring compensation (old)?

Answer 25

results in overstating of earnings, no compensation expense recognized because few companies used fair value method, and options granted disproportionately to top executives

Question 26

How is compensation expense currently accounted for?

Answer 26

debit compensation expense, credit paid in capital (stock options)

Question 27

What are stock appreciation rights?

Answer 27

not paying anything out of pocket but get stock appreciation when price goes up

Question 28

What is the result of stock appreciation rights?

Answer 28

No risk for employees

Question 29

What is the purpose of reporting earnings per share?

Answer 29

allows us to compare between companies and it is the driver of a company's stock price

Question 30

Where are earnings per share reported?

Answer 30

Income Statement

Question 31

What is the main focus for investors?

Answer 31

Earnings per Share

Question 32

What is dilution?

Answer 32

reduction in EPS which results from conversion of other securities into common stock

Question 33

What is purpose of reporting diluted earnings per share?

Answer 33

shareholders want to know extent of reduction in EPS if dilution takes place, report worst case scenario

Question 34

What is the relationship between basic and diluted EPS?

Answer 34

Basic EPS is always higher than diluted EPS

Question 35

How is basic EPS calculated?

Answer 35

(Net Income-Preferred Dividends)/Weighted Average Outstanding Common Shares

Question 36

What is a simple capital structure?

Answer 36

common stock only with no potentially dilutive securities

Question 37

When are preferred dividends subtracted?

Answer 37

when cumulative or declared

Question 38

What is complex capital structure?

Answer 38

Have potentially dilutive securities such as convertible bonds or preferred stock, options or warrants or other rights that could reduce EPS

Question 39

What are dilutive securities?

Answer 39

securities that could reduce EPS

Question 40

What are anti-dilutive securities?

Answer 40

securities that could increase EPS

Question 41

How is diluted EPS calculated?

Answer 41

((Net Income - Preferred Dividends)/Weighted Average Outstanding Common Shares) - Impact of Convertibles - Impact of warrants, options, and other dilutive securities

Question 42

How is the dilutive effect of convertible securities measured?

Answer 42

if-converted method

Question 43

How is the dilutive effect of options and warrants measured?

Answer 43

treasury stock method

Question 44

What are the 3 differences between SARS and Stock Options?

Answer 44

1) No cash payout by employee, 2) Incorporate market price, 3) Record Liability

Question 45

Process of Computing Diluted EPS

Answer 45

1) If-Converted Method for convertible bonds - Interest Savings/New Shares, 2) Treasury Stock Method for stock options - Cash Proceeds, buy back treasury stock, and calculate change in shares

Question 46

What is restricted stock?

Answer 46

Gives employees a certain number of stocks in a certain day and can never go underwater