Chapter 11 - Solution Manual

There would be no difference in the effect on

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There would be no difference in the effect on operating cash flows in the statement of cash flows. Case 11-3 a. Convertible bonds are complex financial instruments comprising two fundamental financial instruments - debt and the option to convert. Financial economics suggests that each feature has value. Hence, the issue price of convertible debt is a function of the two sources of value. The theoretical accounting treatment for convertible bonds would be to separate the fair values of the debt and the option to convert, because it is felt that each has decision relevance to users. Many accounting theorists feel that the option to convert is an equity feature and if a separate value is reported for the option it should be reported as an element of stockholders' equity. This view is consistent with the argument that the value of the option is a function of the value of the stock. The option has value only because it can be converted into stock, hence it is in essence equity. Others contend that the option does not meet the definition of equity because option holders do not act as owners. Rather, they feel that the option is an obligation that should be reported as debt. It is an obligation to issue stock which when satisfied yields capital contributions that are less than what would have been infused into the company had the stock been sold at its then current market price. It is argued therefore, that the conversion is at the expense of preexisting stockholders, hence, the option holder is not acting as an owner. Proponents of this view hold that the value of the option should be separated from debt. Some feel that the separated value should be disclosed as debt, others feel that it should appear between debt and equity, as quasi- equity. Under current generally accepted accounting principles, the value of the option to convert is not separated from debt. Rather the debt is recorded initially at its issue price, and no amount is reported for the option to convert, or equity feature. This treatment is considered practicable because there is no current consensus on how to independently or objectively value the option.
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217 b. FASB Statement No. 150 requires mandatorily redeemable preferred stock not be disclosed within the stockholders' equity section of the balance sheet. Instead, it is disclosed as a liability This disclosure is required because the FASB feels that mandatorily redeemable preferred stock has characteristics that are more like debt than equity - i.e., that there is a probable future sacrifice of resources. However, the SEC does not allow the stock to be included in total liabilities. Hence the SEC appears to consider redeemable preferred stock as quasi equity. c. If convertible debt is issued, the balance sheet would report $100,000 of bonds payable. Each year $10,000 in interest would be paid and reported as an expense. The interest would be tax deductible. Hence, the net effect on reported earnings would be the interest multiplied by one minus the tax rate.
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