Book cover for Intermediate Accounting

Intermediate Accounting

Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield

ISBN #9780470374948

13th Edition

695 Questions

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Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

Chapter 16 provides a detailed exploration of the accounting practices surrounding dilutive securities, earnings per share, and investment measurements. It emphasizes the importance of accurately computing both basic and diluted EPS by considering potential common shares from convertible instruments, and distinguishes between the accounting methods for debt and equity investments. Additionally, the chapter highlights the necessity of recognizing impairments and executing reclassification adjustments to ensure transparent, faithful representation of a company’s financial condition.

Learning Objectives

1

Explain the accounting treatments for dilutive securities and the computation of basic and diluted earnings per share (EPS).

2

Differentiate between measurement methods for debt and equity investments, including the use of amortized cost and fair value approaches.

3

Analyze and compute the impact of potential common shares from convertible bonds, stock options, and warrants on EPS.

4

Evaluate the differences between the equity method and the fair value method in accounting for investments and understand the role of reclassification adjustments.

5

Interpret the importance of transparent and faithful representation in financial reporting to reflect the underlying economic reality.

Key Concepts

CONCEPT

DEFINITION

Dilutive Securities

Financial instruments such as convertible bonds, stock options, and warrants that can potentially increase the number of common shares, thereby diluting EPS.

Basic EPS

A measure of earnings per share calculated using the net income available to common shareholders divided by the weighted average number of common shares outstanding.

Diluted EPS

A version of EPS that includes the impact of all dilutive potential common shares, providing a worst-case scenario for shareholders.

Amortized Cost

A measurement basis for certain financial instruments, where the investment is carried at cost adjusted for principal repayments, amortization of premiums or discounts, and impairment.

Fair Value

The estimated market value of an investment, reflecting current market conditions and expectations, used for measurement of certain equity investments and debt instruments.

Impairment

A permanent reduction in the recoverable amount of a financial asset below its carrying value, which must be recognized in the financial statements.

Equity Method

An accounting approach for investments in which the investor reflects its share of the investee’s net income or loss, rather than just dividends received.

Reclassification Adjustments

Adjustments made to reassign amounts from one classification to another in financial reporting to improve transparency and accuracy.

Example Problems

Example 1

What is meant by a dilutive security?

Example 2

Briefly explain why corporations issue convertible securities.

Example 3

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

Example 4

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."

Example 5

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

QUESTION

How do you compute diluted EPS when a company has convertible bonds outstanding?

STEP-BY-STEP ANSWER:

Step 1: Start with the basic EPS computation from net income divided by the weighted average common shares outstanding.
Step 2: Identify all dilutive securities, such as convertible bonds, stock options, or warrants that could potentially convert into common stock.
Step 3: Calculate the number of additional shares that each dilutive instrument would add if converted into common stock.
Step 4: Adjust the numerator by adding back interest expense (net of tax) related to convertible bonds if these were converted.
Step 5: Adjust the denominator by adding the additional common shares from conversion.
Step 6: Recompute EPS using the adjusted numerator and denominator to arrive at diluted EPS.
Final Answer: The diluted EPS is obtained by dividing the adjusted earnings by the total number of common shares after including all dilutive effects.

Diluted EPS Computation

QUESTION

How do you account for an equity investment measured at fair value versus amortized cost, and what is the impact of an impairment?

STEP-BY-STEP ANSWER:

Step 1: Determine whether the investment is classified under debt or equity and select the corresponding measurement basis (amortized cost for debt investments, fair value for equity investments).
Step 2: For investments at amortized cost, adjust the carrying value over time using the effective interest rate method and account for any premiums or discounts.
Step 3: For investments at fair value, adjust the carrying amount to reflect current market conditions and value fluctuations.
Step 4: Evaluate the investment for impairment by comparing its carrying value to its recoverable amount.
Step 5: If an impairment is identified, write down the carrying amount to the recoverable amount and recognize an impairment loss in the income statement.
Final Answer: The carrying value of the investment is adjusted based on the chosen measurement method, and impairments are recognized to ensure that the investment is not overstated on the financial statements.

Investment Classification and Impairment

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Common Mistakes

  • Failing to include all potential dilutive securities, such as stock options and warrants, when computing diluted EPS.
  • Neglecting the adjustment of interest expense related to convertible bonds, which can lead to an inaccurate diluted EPS calculation.
  • Confusing amortized cost with fair value measurement methods and incorrectly applying them to the wrong types of investments.
  • Overlooking impairment indicators and delaying the recognition of necessary write-downs, thus overstating investment values.
  • Misapprehending the differences between the equity method and the fair value method, leading to errors in investment accounting.