Financial Accounting: Liabilities & Equities

Question 1 (33 marks)Canadian Scientific Ltd. issued €600,000 of convertible bonds on July 1, 20X2. The bonds mature on June 30, 20X9, and bear an interest rate of 7%, paid each June 30. The bonds are convertible at the rate of 100 ordinary shares for every €1,000 bond.

RequiredAnswer each of the following two parts independently.

Part (a) (16 marks: 3 marks for Requirements 1, 2, 3, and 5; 4 marks for Requirement 4)

The bonds are convertible at the option of Canadian Scientific Ltd. The market interest rate on the day of issuance was 7%.

1. Calculate the portion of the bond proceeds allocated to debt versus equity.

2. Prepare a table showing the interest expense over the life of the bond and the amortization of the interest liability.

3. Prepare a table showing the charge to retained earnings for each period for the life of the bond and the change in the equity component.

4. What would appear on the balance sheet, income statement, retained earnings statement, and cash flow statement for the year ended June 30, 20X4? Indicate which category each balance sheet item would fall under. Do not separate the current portion of long-term debt. On the cash flow statement, the direct method is used to disclose operating activities.

5. What items would be included in a disclosure note related to the bond at June 30, 20X4? List the disclosures; you do not need to prepare them.

Part (b) (17 marks: 3 marks for Requirements 1, 2, and 3; 4 marks each for Requirements 4 and 5)

All terms are the same as Part (a), except the bonds are convertible at the investor’s option. The financial instrument was issued for total proceeds of €680,000. The bond alone was valued at €539,602. No value can be separately calculated to value the option.

1. Calculate the portion of the bond proceeds allocated to debt versus equity.

2. What interest rate is implicit in the bond valuation?

3. Prepare a table showing the interest expense and the net bond liability over the life of the bond.

4. What would appear on the balance sheet (indicate category), income statement, and cash flow statement for the year ended June 30, 20X6? Do not separate the current

portion of long-term debt. On the cash flow statement, the direct method is used to disclose operating activities.

5. Prepare a journal entry to reflect the following independent events:

a. Conversion of the bond to ordinary shares on June 30, 20X9.b. Repayment of the bond with cash on June 30, 20X9, and the lapse of rights.

ProcedurePart (a)

1. Open the file FA3L4Q1, which contains the worksheets L4Q1A and L4Q1B. You will use worksheet L4Q1A to complete Part A, requirements 1, 2, and 3.

2. Examine the layout of the worksheet. It is similar to the one used in Computer illustration 4-1.

3. To complete the calculation for Requirement 1, enter PV functions in cells B21 and B22 to determine the PV of the interest and principal. Sum the values in cell B23.

4. Complete the amortization schedule to determine the interest expense for Requirement 2 by entering the appropriate formulas into cells B30 to E36.

5. Complete the table to determine the capital charge to retained earnings for Requirement 3 by entering the appropriate formulas into cells B43 to D49.

6. Save your file.

7. Copy and paste cells A1 to E49 into a word-processing document.

8. Answer Requirements 4 and 5 in your word-processing document.

Part (b)

1. Click the worksheet L4Q1B.

2. Examine the layout of the worksheet.

3. From the information given in the problem, determine the values for Requirement 1 and enter them into cells B21 and B22. Sum the values in cell B23.

4. To complete Requirement 2, enter the required cash flows for the issuer of the bonds in cells B30 to B37. Determine the IRR by entering the correct function in cell C30. Enter this interest rate in B14 and B15.

5. To complete Requirement 3, enter the appropriate formulas into cells B45 to E51.

Note:Adjust cell C51 for rounding error as needed.

6. Save your file.

7. Copy and paste cells A1 to E53 into your word-processing document.

8. Answer Requirements 4 and 5 in your word-processing document.

Question 2 (19 marks)R&P Steering Corporation reported the following balances for shareholders’ equity as of January 1, 20X4:

Share equity – 8% bonds (€10,000,000 par value). Bonds are convertible at maturity into ordinary shares at the company’s option.

€5,002,490

Convertible €8, no-par preference shares, 60,000 shares outstanding; convertible into 8 ordinary shares for every 3 preference shares outstanding.

6,060,000

Class A no-par ordinary shares, unlimited shares authorized, 915,000 issued and 899,000 outstanding

32,940,000

Ordinary share warrants, allowing purchase of 90,000 shares at €32.50 660,000Contributed capital on preference share retirement 55,000Retained earnings 116,300,000Less: Treasury shares, 16,000 ordinary shares (512,000)

Forty thousand ordinary stock options are outstanding to certain employees allowing purchase of one share for every two options held at a price of €27.50 per share. These options expire in 20X7.

The following events took place in 20X4:

a. Ordinary shares were issued to employees under the terms of existing outstanding share options. 16,000 options were exercised when the share market value was €45.

b. Options were issued in exchange for a piece of land, appraised at €75,000. The options allow purchase of 100,000 shares at €15 each in five years. The market value of the shares was €46 on this date. The option was valued at €71,000 using the Black-Scholes option pricing model. (Justify the value used in your entry.)

c. Ordinary shares, 40,000 shares, were acquired and retired at a price of €47 each.

d. Treasury shares, 10,000 shares, were acquired at a price of €44 per share.

e. A cash dividend was declared and paid. The annual dividend for the preference shares and €1 per share for the ordinary shares were both declared and paid.

f. Preference shares, 24,000 shares, converted to ordinary shares.

g. The annual charge on the share equity 8% bonds was recorded.

h. Two-thirds of the ordinary share warrants outstanding at the beginning of the year were exercised when the market value of the shares was €49.50; the remainder lapsed.

i. Preference shares, 10,000 shares, were retired for €107 each.

j. Treasury shares, 20,000 shares, were sold for €32 each.

k. A 10% stock dividend was declared and issued. Treasury shares were not eligible for the stock dividend. The board of directors decided that the stock dividend should be valued at €30 per share. Most of the dividend was issued in whole shares; however, 41,000 fractional shares allowing acquisition of 4,100 whole shares were issued.

Required1. Provide the journal entries for the events listed. (12 marks)

2. Assuming profit for the year was €6,200,000, calculate the closing balances in each of the equity accounts as of December 31, 20X4. (7 marks)

Question 3 (10 marks)a. Which of the following is not a characteristic of a derivative?

1) A derivative is a secondary financial instrument whose value is linked to a primary financial instrument.

2) A derivative is an option.3) A derivative is a forward contract.4) A derivative is an option and a forward contract.5) all of the above

b. Which of the following defines a forward contract?

1) an obligation to buy something in the future2) the right to sell something in the future3) a debt instrument4) the right to buy something in the future

c. S Corporation created a stock option plan for its two top executives. The plan provided that each executive would receive 1,000 options, which would enable him or her to purchase 100 shares at 75 percent of the market price on the date the options became exercisable. The options were exercisable in two years. At the date of granting the options, the market price of the shares was €12 per share. Which of the following is the date of measurement for the stock option plan?

1) date of grant2) end of the first year3) end of the second year4) date the employees exercise their options

d. What are derivatives?

1) legal contracts 2) promissory notes 3) ordinary shares 4) executory contracts

e. Which of the following does the IASB not require to be disclosed for stock options?

1) the number of shares involved 2) market price of the options 3) issue price 4) date of expiry

Question 4 (12 marks)For each of the following independent cases, indicate the appropriate disclosure on the cash flow statement. Be sure to state whether an item is classified in operating, investing, or financing sections. Assume the use of the indirect method of presentation for the operating section of the cash flow statement. (4 marks for each case)

Case A Information from the December 31, 20X5, balance sheet of Riviera Holdings is as follows:

20X5 20X4

Bonds payable €5,000,000 0Discount on bonds payable 160,000 0Ordinary stock conversion rights 695,000 0

During the year, convertible bonds were issued; amortization of the discount was €14,000 in 20X5.

Case B Information from the December 31, 20X5, balance sheet of Baltic Mining Corp. is as follows:

20X5 20X4

Bonds payable €5,000,000 €10,000,000Discount on bonds payable 160,000 346,000Ordinary stock conversion rights 695,000 1,390,000Ordinary shares 17,000,000 7,100,000

One-half of the bonds were converted to ordinary shares during 20X5. Other ordinary shares were issued for cash. Amortization of the discount was €26,000 in 20X5.

Case C Information from the December 31, 20X5, balance sheet of Les Jouets Joyeux is as follows:

20X5 20X4

Bonds payable € 0 €10,000,000Discount on bonds payable 0 26,450Ordinary stock conversion rights 0 1,390,000Contributed capital: lapse of

conversion rights 1,390,000 0

Bonds payable matured in the year, and they were redeemed for cash at par.

Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First Edition (Toronto: McGraw-Hill Ryerson, 2000), Question 15-15, page 897. Adapted with permission.

Question 5 (26 marks)Case analysisYou have been approached by a potential investor to comment on the financial instruments of a company in which she is considering investing. Communications Equipment Ltd. is a small company whose shares are lightly traded on the London Stock Exchange. Control of the ordinary shares is held by a relatively tight-knit group of investors, who have been involved in the company since it went public. There are now shares held outside this control block and many shareholders.

This potential investor wants to make sure she properly understands the debt and equity obligations of the company as part of her due diligence before investing. She’s also investigating the company’s operating results, products, and future markets. However, she knows that you have expertise in financial matters and has come to you for an explanation of two of the enterprise’s more complicated financial instruments. She’s asked you to explain their nature, potential valuation problems, and financial statement classification. She is concerned about earnings dilution and the number of ordinary shares that might be issued in the future.

The financial instruments are described in Exhibit 1.

RequiredRespond to the request.

Exhibit 1COMMUNICATIONS EQUIPMENT LTD.

Financial InstrumentsDecember 31, 20X5

Demand debentures payable, 6% € 7,000,000

Demand debentures are held by three individuals who hold ordinary shares of the company and sit on the board of directors. There is no maturity date on the bonds. Interest is paid annually. On demand, bonds may be converted to 149,300,000 ordinary shares of CEL at the investor’s option, or redeemed for cash. Market interest rates were in the range of 8% in 20X5.

Series C shares, €6 € 12,000,000

Series C shares were issued at par value in 20X5 and are entitled to cumulative dividends, as declared, of €6 annually. The shares have a maturity date of October 31, 20X11. In 20X11, at the shareholders’ option, all shares may be tendered for conversion into ordinary shares at a value of €36.25 per share. At the company’s option at that time, the company may pay cash instead of any or all ordinary shares. Shareholders are also entitled to dividends in arrears, if any, on conversion, in cash.

Note:Case analysis is limited to 1,000 words. A maximum of two marks is awarded for the quality of written communication.

Suggested solutions

Question 1 (33 marks)Computer solutionPart (a) (16 marks)

1, 2, and 3 (3 marks each for present value, amortization schedule, and capital charge)

4. (4 marks)

On June 30, 20X4, end of second year.

Balance sheet

Long-term liabilitiesInterest liability on bond.................................................. 172,208

EquityShare equity-bond............................................................ 427,792

Income statement

Interest expense................................................................ 14,014

Retained earnings statement

FA3: LESSON 4: ASSIGNMENT QUESTION 1: PART A: SOLUTIONCGA-CANADA

DATA TABLE - Canadian Scientific Ltd. (Issuer)

Maturity amount of the bonds € 600,000.00Issue date July 1, 20X2Maturity date June 30, 20X9

Stated annual interest rate 7.00%Interest rate per period 7.00%Market interest rate (annual) 7.00%Interest rate per period 7.00%

Interest payment dates June 30Number of interest periods per year 1Total number of interest periods 7

PV of principal 373,650€ PV of interest payments 226,350Total sale price of bond, July 1, 20X2 600,000€

Amortization Schedule, Issuer's Option:

Beginning Interest EndingYear Balance 7% Payment Balance

1 226,350€ 15,845€ 42,000€ 200,195€ 2 200,195 14,014 42,000 172,2083 172,208 12,055 42,000 142,2634 142,263 9,958 42,000 110,2215 110,221 7,715 42,000 75,9376 75,937 5,316 42,000 39,2527 39,252 2,748 42,000 0

Capital Charge

Beginning Charge Equity EndingYear Balance 7% Account

1 373,650€ 26,155€ 399,805€ 2 399,805 27,986 427,792 3 427,792 29,945 457,737 4 457,737 32,042 489,779 5 489,779 34,285 524,063 6 524,063 36,684 560,748 7 560,748 39,252 600,000

Capital charge on share equity-bond................................ 27,986

Cash flow statement

Operating activitiesInterest paid...................................................................... (14,014)

Financing activitiesPrincipal payment on interest liability on bond(€399,806 – €427,792)..................................................... (27,986)

5. (3 marks)

Disclosure items

1. Terms and conditions2. Interest rate3. Fair value of interest liability

Part (b) (17 marks)

1, 2, and 3 (3 marks each for bond value vs. conversion option value, calculation of IRR, and amortization schedule)

4. (4 marks)

On June 30, 20X6, end of fourth year

Balance sheet

Long-term liabilitiesBonds payable (net)......................................................... 569,621

EquityOrdinary stock conversion rights..................................... 140,398

Income statement

Interest expense...................................................................... 50,501

Cash flow statement

Interest paid............................................................................ (42,000)

5. (4 marks)

a.

June 30, 20X9

Bonds payable........................................................................ 600,000Ordinary stock conversion rights........................................... 140,398

Ordinary stock.................................................................. 740,398

b.

June 30, 20X9Bonds payable........................................................................ 600,000

Cash.................................................................................. 600,000Ordinary stock conversion rights........................................... 140,398

Contributed capital, lapse of rights.................................. 140,398

Question 2 (19 marks)Requirement 1: 1 mark for each entryRequirement 2: 1 mark for each account and 1 mark for the memo

Requirement 1

a. Cash [(16,000/2) €27.50]............................................. 220,000Ordinary shares, no-par, 8,000 shares........................ 220,000

b. Land................................................................................. 71,000Contributed capital: ordinary share rights outstanding................................................................. 71,000

The more reliable of the two numbers should be used. Appraisals are subjective, and option pricing models very dependent on estimates. The two values are very close to one

another, which provides some comfort. The lower of the two values is used as the most conservative.

c. Ordinary shares, no-par, 40,000 shares*.......................... 1,437,200Retained earnings............................................................. 442,800

Cash (€47.00 40,000)............................................. 1,880,000* €32,940,000 + €220,000/(915,000 + 8,000) = €35.93 40,000

d. Treasury shares (10,000 €44)...................................... 440,000Cash............................................................................ 440,000

e. Dividends, ordinary 857,000* €1................................ 857,000Dividends, preference 60,000 €8................................. 480,000

Cash............................................................................ 1,337,000* 915,000 + 8,000 – 40,000 – 26,000 treasury shares

f. Preference shares, 24,000 shares*................................... 2,424,000Ordinary shares, 64,000 shares (24,000 8/3)......... 2,424,000

* €6,060,000/60,000 = €101 24,000

g. Retained earnings, capital charge (€5,002,490 8%).... 400,199Share equity — 8% bond........................................... 400,199

h. Contributed capital: ordinary share warrants................... 660,000Cash (60,000 €32.50)................................................... 1,950,000

Ordinary shares, no-par, 60,000 shares*.................... 2,390,000Contributed capital: lapse of warrants....................... 220,000

* €1,950,000 + €440,000

i. Preference shares (10,000 €101).................................. 1,010,000Contributed capital on preference share retirement (balance) 55,000Retained earnings............................................................. 5,000

Cash (10,000 €107)................................................ 1,070,000

j. Cash (20,000 €32)........................................................ 640,000Retained earnings, loss on sale of treasury shares .......... 92,400

Treasury shares*........................................................ 732,400* €512,000 + €440,000/(16,000 + 10,000) = €36.62 20,000

k. Stock dividends, ordinary*.............................................. 3,003,000Ordinary shares, no-par, 96,000 shares €30.......... 2,880,000Contributed capital: ordinary share fractional   share rights 4,100 €30......................................... 123,000

* 915,000 + 8,000 – 40,000 + 64,000 + 60,000 – 6,000 treasury shares= 1,001,000 10% = 100,100 shares €30

Requirement 2

Share equity — 8% bonds (€5,002,490 + €400,199) €5,402,689

Convertible €8, no-par preference shares(€6,060,000 – €2,424,000 – €1,010,000) 2,626,000

Class A no-par ordinary shares (€32,940,000 + €220,000 – €1,437,200 + €2,424,000

+ €2,390,000 + €2,880,000) 39,416,800Ordinary share rights 71,000Contributed capital: ordinary share fractional share rights 123,000Contributed capital: lapse of warrants 220,000Retained earnings(€116,300,000 + €6,200,000 – €442,800 – €857,000 – €480,000– €400,199 – €5,000 – €92,400 – €3,003,000) 117,219,601Treasury shares (€512,000 + €440,000 – €732,400) 219,600

24,000 ordinary stock options are outstanding to certain employees, allowing purchase of one share for every two options held at a price of €27.50 per share. These options expire in 20X7.

Question 3 (10 marks)a. 5)b. 1)c. 1)d. 4)e. 2)

Question 4 (12 marks)(4 marks for each case)

Case A

Financing ActivitiesIssuance of convertible bonds (1)............................................................ €5,447,000

Operating ActivitiesAdd to net profit:

Non-cash expense; discount amortization......................................... €14,000

* €5,000,000 – (€234,000 + €14,000) + €695,000

Case B

Financing activitiesIssuance of ordinary shares*............................................ € 4,365,000

Operating activitiesAdd to net profit:

Non-cash expense; discount amortization................. €26,000

Note: Bond conversion is a non-cash transaction and is not included on the CFS.

* Opening ordinary shares.................................................. € 7,100,000Bond conversion (€5,000,000 + (€1,390,000 – €695,000)– (€346,000 – €26,000 – €160,000))................................ 5,535,000 As calculated.................................................................... 12,635,000Actual............................................................................... 17,000,000 Issuance for cash.............................................................. € 4,365,000

Case C

Operating activitiesAdd to net profit

Non-cash expense, discount amortization.................. € 26,450

FinancingRedemption of bonds....................................................... (€ 10,000,000)

Note:Since the bonds were redeemed at maturity, the discount must have been amortized to zero prior to maturity through a charge to net profit.

Question 5 (26 marks)Case analysis solutionOverview

Communications Equipment is a public company listed on the London Stock Exchange. Its financial statements would obviously comply with GAAP. The company is controlled by a tightly knit group of original shareholders but now has many smaller outside shareholders. One assumes that their degree of control is minimal.

The task in this case is to classify two financial instruments and explain any valuation problems that would be inherent in their accounting treatment. A potential investor would be concerned about the degrees of potential risk and dilution of earnings caused by other financial instruments.

Issues/alternatives

1. Demand debentures payable — classification/valuation/implications2. Series C shares — classification/valuation/implications

Analysis

1. Demand debentures payable

Legally, this is a demand debenture and thus is a liability. However, the investors can, on demand, convert the debenture to ordinary shares, and thus there is an option embedded in the debenture. This makes it a hybrid financial instrument. On initial recognition, a

value has to be assigned to the option and the proceeds divided between the bond liability, including interest, and the ordinary share option. The latter is an equity account.

The division between debt and equity is normally accomplished in one of two ways. The first way is to calculate the present value of a non-convertible bond with the same features and compare this to the proceeds actually obtained for the convertible bond. The proceeds above this present value are assigned to the conversion option.

In this case, valuation is particularly problematic because the debenture is a demand debenture, due whenever the investors choose to demand payment or shares. Thus, the time span used to calculate the present value of a comparable bond is not easily defined. This is something that the company would have to investigate. The other major variable in the calculation of present value is the interest rate to use. The normal reference point is debt of similar size, term, and risk. Again, this may be very difficult to ascertain in this case because the debentures were issued to shareholders (non-arm’s-length) and may be so unusual that no comparable financial instrument can be identified.

From the perspective of a potential owner of ordinary shares, this financial instrument may mean that a considerable number of ordinary shares will be issued at some time in the future. This may dilute the earnings attributable to ordinary shareholders and their degree of relative control. Before the shares are issued, the debentures provide the lenders/shareholders with a guaranteed return, which the potential ordinary shareholder would not receive.

On conversion, the market value of the ordinary shares issued is not typically recorded. Thus, the relative wisdom of the price versus the number of shares issued is not explicitly reported in the financial statements. From an investor’s perspective, though, it may be interesting to understand the actions of the board of directors by making such a comparison.

2. Series C shares

Series C shares are legally (and substantially) equity and do not pose any particular valuation problems. In the financial statements, they are valued at their issue price. These shares can be converted into ordinary shares, another form of equity. While the company can extinguish the shares by paying cash if it wishes, this does not make the shares a liability, as there is no obligation to pay cash.

Dividends, on the other hand, have to be considered a liability if they are not declared and paid annually. They must be brought up to date at maturity and paid in cash. Therefore, one would expect to see dividends on the retained earnings statement (whether declared or not) and a liability for dividends in arrears recorded in the financial statements if they are not paid annually. Valuation of this dividend obligation would simply be the dividend times the number of shares.

Again, from the perspective of a potential investor, these shares represent a prior claim to earnings, above the claims of the ordinary shareholders. However, this is adequately reported by accruing the dividend obligation. Careful analysis of the financial statements is appropriate. The series C shares themselves represent another potential obligation for the company to issue a considerable number of ordinary shares.

As mentioned for the debentures, the market value of the ordinary shares issued is not recorded on conversion. Thus, the relative wisdom of the price versus the number of shares issued is not explicitly reported in the financial statements.

Conclusion

The demand debentures payable and the Series C shares are both hybrid financial instruments, with some elements of debt and some of equity. Valuation of the debentures is particularly problematic.

Marking key

Note:This marking key is provided for guidance and is not intended to be a complete solution. Since there is no right answer to a case analysis, the marking key provides for more than the maximum mark allocation. Use considerable judgment in applying the key. Award marks for valid approach and commentary, and keep in mind that no student will cover all the points.

Overview

Public company that complies with GAAP (½)Control with small group (½)Investor concerned about risk, earnings dilution, shares to be issued (1)

Maximum 2

Issues/Alternatives

Classification/valuation/implications of demand debentures and series C shares (1)

Maximum 1

Analysis

Demand debentures

Legally a liability (1)Conversion option makes it hybrid (1)Proceeds split between debt and option value on initial recognition (1)Valuation with just PV of bond (1)Valuation with PV of bond and option value, relative (1)Investors not at arm’s-length to the company; on board (1)PV hard to calculate: time period uncertain (1)PV hard to calculate: interest rate unknown (1)

Conclusion: may result in large number of shares issued in the future (1)Dilute earnings, control (1)Now, debenture holders get guaranteed return (1)

No fair values likely recognized on conversion (1)Other valid points (1 each)

Maximum 13

Series C shares

Shares are equity (1)Valued at issue price, no valuation problems (½)No liability, as option for company to pay cash is not an obligation (1)Dividends are a liability (1)Must be paid in cash on conversion (1)Accrue on RE statement and as liability annually (1)Valued at dividend amount (½)Conclusion: Accrual fairly states claim to income (1)Conclusion: Shares represent potential to issue shares in the future (1)No fair values recognized on conversion (1)Other valid points (1 each)

Maximum 8

Communication

Organization, quality of expression0 for unacceptable communication skills1 for weak communication skills2 for acceptable communication skills

Maximum 2

Overall —Maximum 26