Chapter 16: Dilutive Securities and Earnings per Share

Discuss the similarities and the differences between convertible debt and debt issued with stock warrants.

Bridgewater Corp. offered holders of its 1,000 convertible bonds a premium of \(160 per bond to induce conversion into shares of its common stock. Upon conversion of all the bonds, Bridgewater Corp. recorded the \)160,000 premium as a reduction of paid-in capital. Comment on Bridgewater’s treatment of the $160,000 “sweetener.”

Explain how the conversion feature of convertible debt has a value (a) to the issuer and (b) to the purchaser.

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.

What are the arguments for giving separate accounting recognition to the conversion feature of debentures?

(Issuance of Bonds with Warrants) Illiad Inc. has decided to raise additional capital by issuing \(170,000 face value of bonds with a coupon rate of 10%. In discussions with investment bankers, it was determined that to help the sale of the bonds, detachable stock warrants should be issued at the rate of one warrant for each \)100 bond sold. The value of the bonds without the warrants is considered to be \(136,000, and the value of the warrants in the market is \)24,000. The bonds sold in the market at issuance for $152,000.

Instructions

(a) What entry should be made at the time of the issuance of the bonds and warrants?

(b) If the warrants were nondetachable, would the entries be different? Discuss.

Four years after issue, debentures with a face value of \(1,000,000 and book value of \)960,000 are tendered for conversion into 80,000 ordinary shares immediately after an interest payment date. At that time, the market price of the debentures is 104, and the ordinary shares are selling at \(14 per share (par value \)10). At date of issue, the company recorded Share Premium— Conversion Equity of $50,000. The company records the conversion as follows.

Bonds Payable 960,000

Share Premium—Conversion Equity 50,000

Share Capital—Ordinary 800,000

Share Premium—Ordinary 210,000

Discuss the propriety of this accounting treatment.

Four years after issue, debentures with a face value of \(1,000,000 and book value of \)960,000 are tendered for conversion into 80,000 shares of common stock immediately after an interest payment date. At that time, the market price of the debentures is 104, and the common stock is selling at \(14 per share (par value \)10). The company records the conversion as follows. Bonds Payable 1,000,000 Discount on Bonds Payable 40,000 Common Stock 800,000 Paid-in Capital in Excess of Par— Common Stock 160,000 Discuss the propriety of this accounting treatment.

On July 1, 2017, Roberts Corporation issued \(3,000,000 of 9% bonds payable in 20 years. The bonds include detachable warrants giving the bondholder the right to purchase for \)30 one share of \(1 par value common stock at any time during the next 10 years. The bonds were sold for \)3,000,000. The value of the warrants at the time of issuance was $100,000. Prepare the journal entry to record this transaction.

(EPS with Stock Dividend and Discontinued Operations) Christina Corporation is preparing the comparative financial statements to be included in the annual report to stockholders. Christina employs a fiscal year ending May 31.

Income from operations before income taxes for Christina was \(1,400,000 and \)660,000, respectively, for fiscal years ended May 31, 2018 and 2017. Christina experienced a loss from discontinued operations of \(400,000 on March 3, 2018. A 40% combined income tax rate pertains to any and all of Christina Corporation’s profits, gains, and losses.

Christina’s capital structure consists of preferred stock and common stock. The company has not issued any convertible securities or warrants and there are no outstanding stock options.

Christina issued 40,000 shares of \)100 par value, 6% cumulative preferred stock in 2014. All of this stock is outstanding, and no preferred dividends are in arrears.

There were 1,000,000 shares of \(1 par common stock outstanding on June 1, 2016. On September 1, 2016, Christina sold an additional 400,000 shares of the common stock at \)17 per share. Christina distributed a 20% stock dividend on the common shares outstanding on December 1, 2017. These were the only common stock transactions during the past 2 fiscal years.

Instructions

(a) Determine the weighted-average number of common shares that would be used in computing earnings per share on the current comparative income statement for:

(1) The year ended May 31, 2017.

(2) The year ended May 31, 2018.

(b) Starting with income from operations before income taxes, prepare a comparative income statement for the years ended May 31, 2018 and 2017. The statement will be part of Christina Corporation’s annual report to stockholders and should include appropriate earnings per share presentation.

(c) The capital structure of a corporation is the result of its past financing decisions. Furthermore, the earnings per share data presented on a corporation’s financial statements is dependent upon the capital structure.

(1) Explain why Christina Corporation is considered to have a simple capital structure.

(2) Describe how earnings per share data would be presented for a corporation that has a complex capital structure.