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Chapter 7
Financing Activities
7-11
in whole or in part.
the remainder in APIC.
7.10 Convertible Debt under IFRS and U.S. GAAP.
a. U.S. GAAP (all amounts in millions)
CC AOCI RE
1 Cash + 500 Convertible Bonds +500
Shareholders' Equity
+LiabilitiesAssets =
CC AOCI RE
2 Cash –15 Interest Expense –15
Shareholders' Equity
+LiabilitiesAssets =
Interest Expense .................................................................. 15
CC AOCI RE
cConvertible Bonds –500 Common Stock +20
APIC +480
Shareholders' Equity
+LiabilitiesAssets =
Transaction 2: Interest = 3% × $500 = $15. Transaction 3a: Shift book value of
of common equity split between par value of $20 and APIC for the remainder.
Chapter 7
Financing Activities
7-12
b. IFRS (all amounts in millions)
CC AOCI RE
1 Cash +500 Convertible Bonds +332.25 APIC—Convertible
Bonds +167.75
Shareholders' Equity
+LiabilitiesAssets =
CC AOCI RE
2 Cash –15 Convertible Bonds +11.58 Interest Expense –26.58
Shareholders' Equity
+LiabilitiesAssets =
c.
CC AOCI RE
Convertible Bonds –343.83 APIC—Convertible
Bonds +167.75
Common Stock +20.00
APIC +491.58
Shareholders' Equity
+LiabilitiesAssets =
Under IFRS, the proceeds are allocated between the fair values of the notes and
the conversion options on the notes. If ARTL would have paid % interest on the
notes issued without the conversion option, the fair value of the notes could have
been approximated by discounting the note’s contractual cash flows at 8%. The
method to record conversion (Transaction 3). ARTL shifts the amounts recorded
Chapter 7
Financing Activities
7-13
7.11 Bonds Issued with Detachable Warrants.
CC AOCI RE
1
Cash +9,200,000 Bonds Payable +8,808,510.6 APIC—Warrants +391,489.4
Shareholders' Equity
+LiabilitiesAssets =
Journal Entry
The proceeds of $9,200,000 are allocated to the bonds and warrants based on relative
7.12 Effect of Capital and Operating Lease on the Financial Statements.
Income
Statement
Balance Sheet
Statement of
Cash Flows:
Cash Flows
Provided by
Operations
Statement of
Cash Flows:
Cash Used for
Financing
Activities
Operating
Lease
Rent Expense Rent Payable
or Cash
• Increase or
Decrease in
Rent Payable
Capital
Lease
• Depreciation
Expense on
• Increase or
Decrease in
Interest
Payable on
Leased
Liability
• Payments on
Principal on
Capitalized
Lease Obliga-
tion
7.13 Nature of Reserve Accounts. The commonality across all reserve accounts is the
fact that (1) they are liabilities or contra assets on the balance sheet and (2) they
Chapter 7
Financing Activities
7-14
referred to as the reserve for uncollectible receivables. The warranty liability is an
example of a liability account often referred to as the reserve for claims on
defective inventory.
7.14 Accounting for Stock-Based Compensation. Firms adopt stock option plans to
motivate employees to take actions that will increase the market value of a firm’s
common shares. Moreover, unlike compensation in the form of cash salaries and
next decade.
7.15 Valuation of Derivatives. Firms must revalue derivatives held as speculative
investments to market value each period and recognize the resulting gain or loss in
net income.
The following summarizes the accounting for a fair value hedge of an existing
asset or liability:
balance sheet. Also show the cumulative amount of net value changes for the
hedged item and its related derivative in accumulated other comprehensive
income.
Chapter 7
Financing Activities
7-15
• Remove the hedged asset or liability and its related derivative from the accounts
at the time of settlement (for example, at the time of interest payments).
7.16 Accounting for Securitization of Receivables.
a. To record a sale, three criteria must be met:
1. The transferred assets have been isolated from the transferor. The transfer of
satisfy this criterion. Creditors could exert a claim against the company’s re-
access to the receivables themselves.
2. The transferee has the right to pledge or exchange the assets it received, and
the receivables would be a constraint that limits the ability of the trust to
3. The transferor does not maintain effective control over the transferred assets
through (a) an agreement that both entitles and obligates the transferor to re-
purchase or redeem them before maturity or (b) the ability to unilaterally
cause the holder to return specific assets. It appears that Ford Motor Credit
trust.
in Requirement b as a collateralized loan, it would make the following entry:
Chapter 7
Financing Activities
7-16
in whole or in part.
Firms want to avoid recording the debt because it affects their future borrowing
capacity, credit ratings, and debt solvency ratios (for example, long-term debt to
long-term capital and long-term debt to shareholders’ equity ratios). It also
makes the firm look riskier compared to other firms that report securitizations as
and quick ratios).
7.17 Accounting for Off-Balance-Sheet Financing.
The analyst should consider separately the receivables for which the airline
First, consider the receivables underlying the Senior Certificate. The airline states
that it has retained the full amount of the allowance for doubtful accounts related to
these receivables because it “has substantially the same credit risk as if the
and record a liability on its books.
The receivables related to the Subordinate Certificate clearly give rise to a
receivable for the airline. The airline has merely transferred the receivables to a
wholly-owned subsidiary. No cash inflow has occurred. The airline continues to
trust to ensure that debt service costs on its Senior Certificate were paid.
Chapter 7
Financing Activities
7-17
in whole or in part.
7.18 Effect of Capitalizing Operating Leases on Balance Sheet Ratios.
a. Gap Inc. (amounts in millions)
Lease Present Value Present
Lease Payment in: Payment Factor at 8% Value
2009 $1,069 0.92593 $ 989.8
2010 927 0.85734 794.7
*Present value of an annuity of $360 million for three periods, then discounted
back five periods.
Limited Brands
(amounts in millions)
Lease Present Value Present
Lease Payment in: Payment Factor at 8% Value
2009 $ 478 0.92593 $ 442.6
back five periods.
b. Liabilities to Assets Ratio (as reported)
Long-Term Debt Ratio (as reported)
c. Liabilities to Assets Ratio (as restated)
Chapter 7
Financing Activities
7-18
in whole or in part.
Long-Term Debt Ratio (as restated)
7.19 Stock-Based Compensation.
Cola’s tax savings from stock-based compensation is reported as part of income
based compensation in a note to the financial statements, hoping that analysts
will eliminate the expense in their calculations of pro forma earnings.
b. Firms structure stock option plans so that a period of time elapses between the
compensation on the date of the grant by both employees and employer.
c. The fair value of the options granted increased between 2002 and 2003 in part
because the market price of Coca-Cola’s common stock increased between
d. Firms such as Coca-Cola have concluded that the forgone cash flows from sell-
ing shares of stock to employees exercising their options at a price less than the
market price is beneficial to the firms through increased employee motivation.
In theory, the increased motivation leads to higher productivity which, in turn,
Chapter 7
Financing Activities
7-19
in whole or in part.
e. The value of an option at any time is:
• Positively related to the volatility of returns on the stock. The larger the re-
turn volatility, the higher the upside potential to the intrinsic value (but
bounded at zero on the downside).
exercise price.
• Inversely related to the dividend yield. Dividends reduce the stock price in
the amount of the dividend; that is, owners of the stock get their returns in
the form of dividends instead of stock price appreciation.
7.20 Stock-Based Compensation.
a. Stock-based compensation does not require an outflow of cash by Eli Lilly. Be-
cause stock-based compensation is reported as an expense on Lilly’s income
statement and because Lilly uses the indirect method of calculating operating
plans.” The amount reported represents the exercise price multiplied by the
number of options that each employee exercised.
c. Firms structure stock option plans so that a period of time elapses between the
grant date and the date the option becomes in the money (defined as the exercise
d. Eli Lilly states that the nonvested stock option expense of $397.5 million will be
amortized over the remaining service period of two years. Thus, $49.7 million
for the quarter as well, based on the vesting term of the grants.
Chapter 7
Financing Activities
7-20
in whole or in part.
e. Analysts differ in their views on the more relevant earnings per share number.
Some believe that stock-based compensation should be reported on the income
statement because it is a legitimate cost of doing business and should be
matched against the revenue reported for the period. They are less concerned
the income statement because of its subjectivity and the fact that entire indus-
tries will be negatively affected if such charges are mandated. These analysts
believe that disclosure is adequate.
7.21 Stock-Based Compensation—Vesting and Valuation Models.
vesting feature in stock option plans to induce employees to remain with the
firm.
b. Coca-Cola reports vesting periods of one to four years for options granted in
grantees, which generally equals the vesting period.”
c. (1) For both Coca-Cola and Eli Lilly, the options have a ten-year life.
(2) See Requirement b for the vesting periods for each firm.
sequences and grantees’ decision as to when to exercise options often is part
of a comprehensive tax-planning scheme.
