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Financial Reporting and Analysis (6th Ed.)
Chapter 15 Solutions
Financial Reporting for Owners’ Equity
Cases
Cases
C15-1. Groupe Casino: Determine whether it is debt or equity
Requirement 1:
International Accounting Standards (IAS) No. 32 states that “[t]he issuer
of a financial instrument shall classify the instrument, or its component
the assets of the entity after deducting all of its liabilities.
Requirement 2:
Equity treatment seems appropriate in this case. The notes have no
maturity date and the lender cannot force redemption. Moreover, interest
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equity shares, so there is no contractual obligation to settle the note with
equity or equity-like instruments. However, the notes carry no voting
rights nor do they seem to represent a strong “residual” claim to the assets
of the entity.
Requirement 3:
DR Interest on perpetual obligation notes 30
CR Interest payable 30
To record the interest payment on December 31, 2005 (in millions of euros)
DR Interest payable 30
CR Cash 30
The ASC Glossary defines a financial liability as “a contract that imposes
on one entity an obligation to do either of the following: (a) deliver cash or
another financial instrument to a second entity; or (b) exchange other
financial instruments on potentially unfavorable terms with the second
entity.”
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include convertible debt or preferred stock that by its terms either must be
redeemed by the issuing entity or is redeemable at the option of the
investor.”
C15-2. Employee stock option accounting at Starbucks Corporation
Requirement 1:
A stock option’s fair value increases with the duration of the option—the
period of time over which the option may be converted into shares of stock.
two years after the options have vested. This historical pattern means that
the options vesting December 31, 2013 are likely to be exercised in 2015 and
thus have an expected term of just three years. The tranche that vests on
December 31, 2016, on the other hand, is likely to be exercised in 2018 and
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January 1, 2013:
DR Deferred compensation expense $50,000
CR Paid-in capital—stock options $50,000
($40) exceeds the option exercise price at December 31, 2013.
Requirement 3:
X $3.20 fair value per option). This measured compensation expense must be
recognized pro-rata over the two-year vesting period. So, the amount of
compensation expense to be recognized in 2014 is $40,000. Notice that
compensation expense does not depend on the market value of SBUX shares
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shares has to almost double before the options can be exercised at a favorable
price. Employees will assign little or no value to the options if they believe the
chance of SBUX reaching $19 or above is remote. A lower exercise price ($15)
can overcome this lack of incentive/retention value.
C15-2. RN Nabisco Group: Dividends and agency costs
This case describes a “partial spin–off” in which RJR Holdings is offering to
sell 25% of its ownership interest in a subsidiary—the Nabisco Group—to the
public. The plan is to create a market for Nabisco Group shares that is
were a separate Delaware company. Since most U.S. companies are
incorporated in Delaware, no unusual problems surface from this portion of
the passage. However, the second portion places an additional restriction on
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Group “on a substantially consistent basis.” Now we have a potential agency
problem!
To illustrate the nature of this agency problem, suppose Nabisco Group
reports net income of $100 million. With the dividend payout set at 45%, this
means that Nabisco investors should receive $45 million in dividends. But
who are those investors? Under the proposed offering, Nabisco Group would
Nabisco Stock
Reynolds Stock
($ in millions)
Outsiders
Holdings
Outsiders
Buyout
Group
Nabisco Group pays $45 million dividend:
25% to outsiders with the remainder to Holdings
$11,250
$33,750
Holdings “pass through” of its share:
51% to outsiders with remainder to buyout group
$17,213
$16,538
$45 million management fee and to dispense with the dividend payment.
Earnings at Nabisco Group fall to $55 million (ignoring tax considerations),
but $45 million cash is transferred to Holdings. And, let us suppose that
Holdings now decides to declare a $45 million dividend on Reynolds stock.
Here is what would happen:
Nabisco Stock
Reynolds Stock
($ in millions)
Outsiders
Holdings
Outsiders
Buyout
Group
Nabisco Group pays $45 million management fee:
$0,000
$45,000
Holdings pays $45 million dividend:
51% to outsiders with remainder to buyout group
$22,950
$22,050
Now the buyout group receives $22,050,000 instead of just $16,538,000, and
Nabisco outsiders get nothing. The buyout group, consisting of RJR Nabisco
management and directors, can transfer wealth from outside Nabisco
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value of Reynolds stock held by outsiders and the buyout group since
Holdings owns 75% of Nabisco. This possibility should lessen the agency
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C15-3. Classifying as equity or debt
Part A: Aon Corporation’s Mezzanine Preferred Stock
1. Aon Corporation creates Aon Capital, a separate legal entity.
2. Aon Capital issues $800 million in preferred stock to outside investors who
pay cash.
3. Aon Capital then loans the cash to Aon Corp. in exchange for the junior
debentures.
1. Aon Corporation pays $65.64 million ($800 million x 0.08205) to Aon
Capital as interest on the debentures.
2. Aon Capital than pays this same amount ($65.64 million) to investors as
the required preferred dividend.
Requirement 3:
For financial reporting purposes, Aon Capital will be consolidated with Aon
possibility that investors prefer holding the “stock” rather than the junior
debentures (again perhaps because of a tax advantage).
A second reason to create Aon Capital is to keep the “debt” off of the books
150), which now requires mandatorily redeemable preferred stock to be
shown as debt on the balance sheet (and the dividend to be shown as
interest expense). Aon’s balance sheet complies with GAAP (and SEC rules)
prevailing at the time and shows the redeemable preferred in the “mezzanine”
section.
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Part B: Cephalon Inc.’s Zero-Coupon, Zero Yield-to-Maturity
Convertible Notes
Requirement 1:
The following entry was made when the convertible notes were issued:
$516.146 million (or $750.000 – $233.854) for the conversion option.
Requirement 3:
The following entry would be made when the notes are issued on June 11,
2003:
DR Cash $750.000
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Interest expense would then total only $7.842 million (or $14.031 x 204 / 365)
and the company would make the following entry at year-end:
DR Interest expense $7.842
CR Notes payable $7.842
No other entries are required.
holders’ ability to convert. Once these restrictions are no longer in force,
Cephalon will include the Notes in the computation of diluted EPS using the
“if converted” method described in the text.
Requirement 5:
As the book goes to press, the FASB is still deliberating changes to the
The following entry was made when the convertible debentures were
originally issued:
DR: Cash $300 million
CR: Convertible Debt $300 million
Notice that the entire proceeds were assigned to the liability component of
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Interest expense would be recorded at 7% per year, based on the amount
11).
Requirement 3:
IFRS rules also require separation of the embedded conversion option from
the debt instrument, as illustrated in Requirement 2 and in the chapter.