Question

Question Three

a. Richmond Co. sold convertible bonds at a premium. Interest is paid on May 31 and November 30. On May 31, after interest was paid, 100, $1,000 bonds are tendered for conversion into 3,000 shares of $10 par value ordinary shares that had a market price of $40 per share. How should Richmond Co. account for the conversion of the bonds into ordinary shares under the book value method? Discuss the rationale for this method.   

b. Wilson's Corporation is one of your new audit clients. The corporation's accountant is uncertain how to report earnings per share in accordance with IFRS and is requesting that you provide the following information:  

Define the term 'earnings per share' as it applies to a corporation with a capitalization structure composed of only one class of ordinary shares. Explain how earnings per share should be computed and how the information should be disclosed in the corporation's financial statements.         

c. Discuss the accounting treatment, if any that should be given to each of the following items in computing earnings per share of ordinary shares for financial statement reporting.   

i) Outstanding preference shares issued at a premium with a par value liquidation right.  

ii) The exercise at a price below market value but above book value of an ordinary share option issued during the current fiscal year to officers of the corporation.  

iii) The replacement of a machine immediately prior to the close of the current fiscal year at a cost 20% above the original cost of the replaced machine. The new machine will perform the same function as the old machine that was sold for its book value.       

iv) The declaration of current dividends on cumulative preference shares.

v) The acquisition of some of the corporation's outstanding ordinary shares during the current fiscal year. The shares were classified as treasury shares.

vi) A 2-for-1 share split of ordinary shares during the current fiscal year.

vii) A provision created out of retained earnings for a contingent liability from a possible lawsuit.  

Answer 1

ANSWER a.

1. On conversion of bonds under the book value method, Bonds Payable A/c is debited for the face value, Premium on Bonds Payable A/c debited, and Common Stock A/c is credited at par for the shares issued.

2. Under the book value method, no gain or loss due to conversion is recorded. The amount to be recorded for the stock is equal to the book value which is, face value plus unamortized premium of the bonds.

3. Capital Paid in Excess of Par A/c would be credited for the difference between the book value of the bonds and the par value of the stock issued.

4. The rationale for the book value method is that the conversion is the completion of the transaction initiated when the bonds were issued. Since this is viewed as a transaction with stockholders, no gain or loss is recognized.

ANSWER b.

1. Earnings per share, as it applies to a corporation with a capitalization structure composed of only one class of ordinary shares, is the amount of earnings applicable to each share of ordinary shares outstanding during the period for which the earnings are reported.

2. The computation of earnings per share should be based on a weighted average of the number of shares outstanding in the period.

If there are stock splits or dividends, they are to be recognised retrospectively , except relatively small non recurring stock dividends which may be ignored. The computation should be made for income before extraordinary items, extraordinary items net of income tax, and net income.

3. The earnings per share from each of the foregoing should be presented in the income statement and it is desirable that the method of computation be disclosed.

Generally accepted accounting principles also require that earnings per share be disclosed on the face of the income statement.The earnings per share amount for each category is to be calculated by dividing the dollar amount of the gain or loss associated with that category by the number of common shares outstanding. These breakdowns allow users to focus on the components of earnings per share.

ANSWER c.

i) Outstanding preference shares issued at a premium with a par value liquidation right will affect the determination of book value per share which is the box value of a company divided by the number of shares that are outstanding. This is determined for each individual shares after the debts are paid. Preference share dividends should be subtracted from net income before computing earnings per share to arrive at income available to ordinary shareholders. Therefore, the computation of earnings per share for common stock will not be affected except with respect to the preference share dividends.

ii) Options are special rights given to certain selected people, such as employees in order to acquire ordinary shares directly from the company. Normally, the company will fix the exercise price when the options are granted. The terms of the options will include an exercise period within which the holders of the options will have to exercise their rights to acquire the shares.

According to the situation, the exercise price of the ordinary shares option issued during the current fiscal year to employees of the corporation is below market value but above book value. The holders of the options will be inclined to exercise their rights due to the exercise price is lower than the current market value. As the result, there will be an increase in the number of shares outstanding.

The computation of earnings per share should be based in the weighted average number of shares outstanding during that period. The exercise of share option would not affect earnings; however, any compensation to the officers would reduce net income and earnings per share.

iii) The replacement of a machine immediately prior to the close of the current fiscal year at a cost 20% above the original cost of the replaced machine will not affect the computation of earnings per share for that year. As the old machine was sold for its book value, there is no gain or loss on disposal, therefore earnings are also unaffected.

Besides that, replacement of a machine will not affect weighted average of the number of shares outstanding during the period. Therefore, calculation of EPS is not affected by this factor

iv)As per the standard on Earnings Per Share , it is stated that the preference dividends are deducted for cumulative preference shares as amount due during the fiscal year regardless whether the preference dividends have been declared for the year. Meanwhile, any dividends in arrears brought forward are not supposed to include preference dividends for the purpose of calculating the earnings per share.

Hence, the declaration of current dividends on cumulative preference shares should be deducted from the income from continuing operations, income before extraordinary items, and net income before computing earnings per share applicable to the ordinary shares and other residual securities. As the preference shares are cumulative, it is appropriate regardless the amounts of the preference dividends are declared or paid.

v) Treasury shares are shares previously sold that are reacquired by the issuing company. When a corporation buys back some of its issued and outstanding stock, the transaction affects retained earnings indirectly. Since both retained earnings and treasury stock are reported in the stockholders' equity section of the balance sheet, amounts available to pay dividends decline. The cost of treasury shares must be subtracted from retained earnings, reducing amounts the company can distribute to stockholders as dividends.

When a corporation buys back some of its own stock, it reduces the number of shares issued and outstanding, increasing the corporation's earnings per share.

vi) Share split transactions involves the division of issued shares of an entity into a greater number of shares without any further consideration from the shareholders.The shareholder would have the same net interest in the company but his interest would be represented by a different number of shares.

Share split transactions are treated in the EPS calculation in the same manner as bonus shares, i.e. the weighted average shares are increased by the number of additional shares issued in the year of the share split transaction and as well as in any comparative prior periods presented as though the shares had been split from the beginning of the comparative prior period presented.

Therefore, an adjustment is made to increase the number of shares resulting from the share split in the current period. A 2-for-1 stock split will result in an EPS of half the amount of the pre-split earnings or what the earnings would have been had the split not occurred. The stock split effect on EPS is the increase in number of company shares due to the split declaration.

vi) A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability is recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm.

But, it does not affect the EPS as it only recorded to ensure financial statements are accurate and meet GAAP nad IFRS requirements.