Chapter 11 - Solution Manual

Stated differently providing an option to continue

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Stated differently, providing an “option” to continue the use of historical-cost based measurement will lead to accounting that potentially misrepresents the underlying economics. We do not share the FASB’s belief that fair value measure of a company’s liabilities is preferable to historical cost. If management is not going to extinguish debt in the near term, then adjusting it to fair value will not provide the user to figures with which to project future cash flows (an objective of financial reporting, described in SFAC No. 1). Perhaps a criterion based on management intent would be preferable to providing a blanket option to elect fair value. However, past management practices of deceit would indicate that even this criterion would likely result in reduced, rather than enhanced financial statement transparency.
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253 Debate 11-3 Convertible debt Should we separate the debt and equity features of convertible debt? Team 1: Pro Separation. Present arguments in favor of separating the debt and equity features of convertible debt. Convertible debt is a complex financial instrument. Complex financial instruments combine two or more fundamental financial instruments. Convertible debt combines two fundamental financial instruments – debt and equity (the option to convert). The conversion feature has a value that is derived from the value of the stock, not the debt. That value should be separated from the issue price of the convertible debt and reported in the balance sheet as equity, just like other options whose value derives from the value of stock are reported. Convertible debt can be converted into a predetermined number of shares of the issuing company’s capital stock. From the investor’s perspective, convertible debt has a value-added component built into it – the option to convert the debt into equity. As a result, the debt sells for more than it would, if it were issued as straight debt. This extra issue price is the value of the option to convert. The option is not debt and its value should be reported separately from the value of the debt itself. Stated differently, the issuing company has issued two things as a package deal to the investor – debt (a bond) and the option to convert the debt. The convertible debt can be viewed as similar to debt issued with warrants attach. The warrants give the investor the right to purchase equity shares at a predetermined price. Since this is an issuance of two things – debt and options to purchase shares the issue price is separated into its debt and equity components and reported in the balance sheet as debt and equity. We argue that the same treatment should be afforded to convertible debt. The value of the equity feature (the option to convert) should be separated from the value of the debt itself and the two items (debt and equity) should be reported separately in the balance sheet. Current accounting practice treats convertible debt as straight-debt. It does not separate the option to convert from the debt. We believe that this overstates the amount of debt owed by the company. As a result, the amount of interest expense reported in the income statement is understated each accounting period. This makes the debt look like it was issued at a more favorable interest rate than it actually was.
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