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Chapter 16 Dilutive Securities and Earnings per Share · 16-1 CHAPTER 16 DILUTIVE SECURITIES AND EARNINGS PER SHARE This IFRS Supplement provides expanded discussions of accounting guidance under International Financial Reporting Standards (IFRS) for the topics in Intermediate Accounting. The discussions are organized according to the chapters in Intermediate Accounting (13th or 14th Editions) an
  Chapter 16Dilutive Securities and Earnings per Share·16-1 ILLUSTRATION 16-1 Convertible DebtComponents Fair value of convertible debtat date of issuance (with bothdebt and equity components) Equity component atdate of issuance (without the debtcomponent) Fair value of liability componentat date of issuance, based onpresent value of cash flows   As indicated, the equity component is the residual amount after subtracting the liabil-ity component. IFRS does not permit companies to assign a value to the equity amountfirst and then determine the liability component. To do so would be inconsistent withthe definition of equity, which is considered a residual amount. [2] To implement the with-and-without approach, companies do the following: 1. First, determine the total fair value of the convertible debt with  both the liability andequity component. This is straightforward, as this amount is the proceeds receivedupon issuance. 2. The company then determines the liability component by computing the net presentvalue of all contractual future cash flows discounted at the market rate of interest.This market rate is the rate the company would pay on similar non-convertible debt. 3. In the final step, the company subtracts the liability component estimated in the sec-ond step from the fair value of the convertible debt (issue proceeds) to arrive at theequity component. That is, the equity component is the fair value of the convertibledebt without the liability component Accounting atTime of Issuance To illustrate the accounting for convertible debt, assume that Roche Group (DEU) issues2,000 convertible bonds at the beginning of 2011. The bonds have a four-year term witha stated rate of interest of 6 percent, and are issued at par with a face value of 􂂬 1,000per bond (the total proceeds received from issuance of the bonds are 􂂬 2,000,000). Interestis payable annually at December 31. Each bond is convertible into 250 ordinary shareswith a par value of 􂂬 1. The market rate of interest on similar non-convertible debt is9percent. CHAPTER 16 DILUTIVE SECURITIES AND EARNINGS PER SHARE This IFRS Supplement provides expanded discussions of accounting guidance underInternational Financial Reporting Standards (IFRS) for the topics in IntermediateAccounting. The discussions are organized according to the chapters in Intermediate Accounting (13 th or 14 th Editions) and therefore can be used to supplement the U.S.GAAPrequirements as presented in the textbook. Assignment material is provided foreach supplement chapter, which can be used to assess and reinforce studentunderstanding of IFRS. ACCOUNTING FOR CONVERTIBLE DEBT Convertible debt is accounted for as a compound instrument  because it contains botha liability and an equity component. IFRS requires that compound instruments beseparated into their liability and equity components for purposes of accounting. [1] Companies use the “with-and-without” method to value compound instruments.Illustration 16-1 identifies the components used in the with-and-without method. U.S. GAAP P ERSPECTIVE Under U.S.GAAP,all of theproceeds of convertible debtare recorded as long-termdebt unless the settlement is in cash.  16-2· IFRS Supplement The equity component of Roche’s convertible debt is then computed as shown in Illus-tration 16-4. Present value of principal: 􂂬 2,000,000  .70843 (Table 6-2;  n   4,  i  9%)  􂂬 1,416,850Present value of the interest payments: 􂂬 120,000  3.23972 (Table 6-4;  n   4,  i    9%)388,766Present value of the liability component  􂂬 1,805,616 ILLUSTRATION 16-3 Fair Value of LiabilityComponent of ConvertibleBond Fair value of convertible debt at date of issuance  􂂬 2,000,000Less: Fair value of liability component at date of issuance1,805,616Fair value of equity component at date of issuance  􂂬 194,384 ILLUSTRATION 16-4 Equity Component of Convertible Bond The journal entry to record this transaction is as follows. Cash2,000,000Bonds Payable1,805,616Share Premium—Conversion Equity194,384 The liability component of Roche’s convertible debt issue is recorded as BondsPayable. As shown in Chapter 14, the amount of the discount relative to the face valueof the bond is amortized at each reporting period so at maturity, the Bonds Payable ac-count is reported at 􂂬 2,000,000 (face value). The equity component of the convertible bond is recorded in the Share Premium—Conversion Equity account and is reportedin the equity section of the statement of financial position. Because this amount is con-sidered part of contributed capital, it does not change over the life of the convertible. 1 Settlementof Convertible Bonds We illustrate four settlement situations: (1) repurchase at maturity, (2) conversion atmaturity, (3) conversion before maturity, and (4) repurchase before maturity. Repurchase at Maturity. If the bonds are not converted at maturity, Roche makes thefollowing entry to pay off the convertible debtholders. Bonds Payable2,000,000Cash2,000,000(To record the purchase of bonds at maturity) Because the carrying value of the bonds equals the face value, there is no gain or losson repurchase at maturity. The amount srcinally allocated to equity of 􂂬 194,384 eitherremains in the Share Premium—Conversion Equity account or is transferred to SharePremium—Ordinary. 1 Transaction costs related to the liability and equity components are allocated in proportionto the proceeds received from the two components. For purposes of homework, use the SharePremium—Conversion Equity account to record the equity component. In practice,there may beconsiderable variance in the accounts used to record this component. The liability component of the convertible debt is computed as shown in Illustration 16-3. ILLUSTRATION 16-2 Time Diagram forConvertible Bond 01234 i  = 9% 􂂬 120,000  􂂬 120,000  􂂬 120,000  􂂬 120,000 Interest 􂂬 2,000,000 Principal n  = 4  PV  V– OA      PV–OA PV  V    PV  The time diagram in Illustration 16-2 depicts both the interest and principal cash flows.  Chapter 16Dilutive Securities and Earnings per Share·16-3Conversion of Bonds at Maturity. If the bonds are converted at maturity, Roche makesthe following entry. Share Premium—Conversion Equity194,384Bonds Payable2,000,000Share Capital—Ordinary500,000Share Premium—Ordinary1,694,384(To record the conversion of bonds at maturity) As indicated, Roche records a credit to Share Capital—Ordinary for 􂂬 500,000 (2,000 bonds  250 shares   􂂬 1 par) and the remainder to Share Premium—Ordinary for 􂂬 1,694,384. There is no gain or loss on conversion at maturity. The srcinal amountallocated to equity ( 􂂬 194,384) is transferred to the Share Premium—Ordinary account.As a result, Roche’s equity has increased by a total of 􂂬 2,194,384 through issuance andconversion of the convertible bonds. This accounting approach is often referred to asthe book value method in that the carrying amount (book value) of the bond and relatedconversion equity determines the amount in the ordinary equity accounts. Conversion of Bonds before Maturity. What happens if bonds are converted before matu-rity? To understand the accounting, we again use the Roche Group example. Ascheduleof bond amortization related to Roche’s convertible bonds is shown in Illustration 16-5. SCHEDULE OF BOND AMORTIZATION E FFECTIVE -I NTEREST M ETHOD 6% B OND D ISCOUNTED AT 9% Cash Interest Discount Carrying Amount DatePaidExpenseAmortizedof Bonds1/1/11  􂂬 1,805,61612/31/11  􂂬 120,000  􂂬 162,506  􂂬 42,5061,848,12212/31/12120,000166,33146,3311,894,45312/31/13120,000170,50150,5011,944,95412/31/14120,000175,04655,0462,000,000 ILLUSTRATION 16-5 Convertible BondAmortization Schedule Assuming that Roche converts its bonds into ordinary shares on December 31, 2012,Roche debits the Bonds Payable account for its carrying value of 􂂬 1,894,453 (seeIllustration 16-5). In addition, Roche credits Share Capital—Ordinary for 􂂬 500,000(2,000  250  􂂬 1) and credits Share Premium—Ordinary for 􂂬 1,588,837. Theentry torecord this conversion is as follows. Share Premium—Conversion Equity194,384Bonds Payable1,894,453Share Capital—Ordinary500,000Share Premium—Ordinary1,588,837(To record the conversion of bonds before maturity) There is no gain or loss on conversion before maturity: The srcinal amount allocatedto equity ( 􂂬 194,384) is transferred to the Share Premium—Ordinary account. Repurchase before Maturity. In some cases, companies decide to repurchase the convert-ible debt before maturity. The approach used for allocating the amount paid uponrepurchase follows the approach used when the convertible bond was srcinally issued.That is, Roche determines the fair value of the liability component of the convertible bonds at December 31, 2012, and then subtracts this amount from the fair value of theconvertible bond issue (including the equity component) to arrive at the value forthe equity. After this allocation is completed: 1. The difference between the consideration allocated to the liability component andthe carrying amount of the liability is recognized as a gain or loss, and 2. The amount of consideration relating to the equity component is recognized (as areduction) in equity. [3]  16-4· IFRS Supplement To illustrate, instead of converting the bonds on December 31,2012, assume thatRoche repurchases the convertible bonds from the bondholders. Pertinent informationrelated to this conversion is as follows.ãFair value of the convertible debt (including both liability and equity components), based on market prices at December 31, 2012, is 􂂬 1,965,000.ãThe fair value of the liability component is 􂂬 1,904,900. This amount is based oncomputing the present value of a non-convertible bond with a two-year term (whichcorresponds to the shortened time to maturity of the repurchased bonds.)We first determine the gain or loss on the liability component, as computed in Illustra-tion 16-6. Present value of liability component at December 31, 2012 (given above)  􂂬 1,904,900Carrying value of liability component at December 31, 2012 (per Illustration 16-5)(1,894,453)Loss on repurchase  􂂬 10,447 ILLUSTRATION 16-6 Gain or Loss on DebtRepurchase Fair value of convertible debt at December 31, 2012 (  with equity component  )  􂂬 1,965,000Less: Fair value of liability component at December 31, 2012 (similar 2-yearnon-convertible debt)1,904,900Fair value of equity component at December 31, 2012 (  without debt component  )  􂂬 60,100 ILLUSTRATION 16-7 Equity Adjustment onRepurchase of ConvertibleBonds Roche has a loss on this repurchase because the value of the debt extinguished isgreater than its carrying amount. To determine any adjustment to the equity, we com-pute the value of the equity as shown in Illustration 16-7.Roche makes the following compound journal entry to record the entire repurchasetransaction. Bonds Payable1,894,453Share Premium—Conversion Equity60,100Loss on Repurchase10,447Cash1,965,000(To record the repurchase of convertible bonds) In summary, the repurchase results in a loss related to the liability component and areduction in Share Premium—Conversion Equity. The remaining balance in SharePremium—Conversion Equity of 􂂬 134,294 ( 􂂬 194,384  􂂬 60,000) is often transferred toShare Premium—Ordinary upon the repurchase. Induced Conversions Sometimes, the issuer wishes to encourage prompt conversion of its convertible debt toequity securities in order to reduce interest costs or to improve its debt to equity ratio.Thus, the issuer may offer some form of additional consideration (such as cash orordinary shares), called a “sweetener,” to induce conversion . The issuing companyreports the sweetener as an expense of the current period. Its amount is the fair valueof the additional securities or other consideration given.Assume that Helloid, Inc. has outstanding $1,000,000 par value convertible deben-tures convertible into 100,000 ordinary shares ($1 par value). Helloid wishes to reduceits annual interest cost. To do so, Helloid agrees to pay the holders of its convertibledebentures an additional $80,000 if they will convert. Assuming conversion occurs,Helloid makes the following entry. Conversion Expense80,000Bonds Payable1,000,000Share Capital—Ordinary100,000Share Premium—Ordinary900,000Cash80,000
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