Generally Accepted Accounting Principles Essay Example

Generally Accepted Accounting Principles Essay Example Generally Accepted Accounting Principles Essay Generally Accepted Accounting Principles Essay If the instrument is classified as debt, the annual payments are classified as interest expense, which reduces earnings, and the redemption premium is corded as a loss on retirement, also reducing earnings. (If the $6,000 excess of retirement price over par were contracted in advance, it would be accrued over the life of the liability). If the financial instrument were equity, both items would reduce retained earnings directly, by-passing earnings. 5. Retractable preferred shares are preferred shares that must be paid back with cash at a specific time, or paid in cash at the option of the shareholder. Because the agreement to pay out the redemption price is legally enforceable, such shares are classified as debt. 6. The principal of convertible debt is classified as equity if it is mandatory convertible into a fixed number of shares. The portion related to annual interest is an unavoidable cash obligation of the company and must be classified as a liability. Thus, the security is compound financial instrument. If the convertible debt is convertible at the investors option, the initial proceeds are divided between the debt element (both principal and interest) and the equity element, the conversion option. 7. If a convertible bond has a conversion price that is set in reference to the air market value of shares on the conversion date, then the bond is classified entirely as debt. No (price) risk or reward is transferred to the investor and therefore there is no equity element. 8. When a convertible bond is converted, the common share conversion option account is transferred into the common stock account. If the bond is not converted, this account is still left in equity, but transferred to a different contributed capital account. 9. Interest expense, $76,400 x . 08 = $6,112 Annual payment, $400,000 x . 08 = $32,000 10. : Stock options provide the holder with an option to acquire a specified umber of shares in a corporation under prescribed conditions and within a stated future time period. Options that are issued as an attachment to other securities are called stock warrants. Warrants may trade separately while options do not. Options often have a limited life while warrants often have no expiry date. 1 1 . A share-based payment to a supplier is measured based on the fair value of the goods or services rendered. In the rare circumstances that these cannot be valued, then the fair value of the rights is used to measure the transaction. 12. If stock rights are recognized on issuance, the stock rights account is rendered into the common stock account on exercise and into a different contributed capital account if options are allowed to lapse. This is identical to the treatment given to the common share conversion option account for convertible bonds. 13. A share-based compensation contract would result in recognition of an equity account if the contract is share-settled, or required issuance of shares. The contract would result in recognition of a liability element if the contract was cash-settled, meaning that compensation is required to be paid in cash. An equity-settled plan is trued up only to the retention rate; he fair value is estimated on initial grant date and is not adjusted to the value that employees receive. 17. A Sara program involves a payment to the employee at the settlement date. The value paid is equal to the fair value of the shares on the payment date, less some reference price, which is usually the fair value of the shares when the Sara were granted. That is, the employee receives a payment (cash or shares) equal to the appreciation in stock price over the life of the Sara. 18. A derivative is an exchange contract meant to transfer risk. It is a secondary financial instrument whose value is linked to a primary financial instrument, an index, or a commodity. Derivatives are options, futures or forward contracts, or a combination of these. Derivatives embody an exchange of financial instruments at fixed terms. A hedge is a way to offset risk to which the company would otherwise be exposed. For an item to be a hedge, the company must first have risk in an area, and then put a hedge in place to counter the risk. That is, a loss on a primary instrument will offset a gain on a hedge instrument. 9. The company could hedge against the risk of exchange fluctuations by entering into a forward exchange contract with a bank to deliver US dollars. The price to be paid would be set by the terms of the contract, and would not fluctuate. The contract would be recorded at cost, and revalued to fair market value annually. Changes in market value of BOTH the transaction balance and the hedge would be reported as gains/losses in earning s and offset. 20. Disclosure for financial instruments is required in the following general categories [per text listing]: 1 . The important components of each financial statement category; e. G. , various loans. 2. Information related to fair value for liabilities. Methods used to assess fair value must be explained. When a financial instrument has been valued at fair value, detail about the change in fair value is required. 3. Information related to the legal terms of the financial instrument, including maturity dates, interest rates, collateral, etc. 4. Various revenue and expense amounts and OIC reserve amounts must be disclosed separately, including interest expense, changes in equity reserve accounts, etc. . Information on exposure to various sources Of risk, as appropriate. Risks might include credit, risk, liquidity risk and market risk. Objectives, policies, and processes or managing risk must be disclosed. Such disclosure is extensive, and includes both qualitative and quantitative elements. 6. Accounting policy information is required as a matter of course for all financial statement elements. Ext ensive disclosure is required to describe the terms of the financial instrument. 15-AI to 15-AAA Financial restructuring; material posted on Connect. 1 . A financial restructuring happens when a company that is in legal violation of debt agreements is financially reorganized and allowed to continue operating, rather than be placed in receivership or bankruptcy. Restructuring an involve a financial reorganization (substantial realignment of debt and equity) or a troubled debt restructuring (lenders settle for less). 2. Financial restructuring may be bound by the following principles or rules, although there are no explicit standards in Canada: a. Accounting entries must reflect the terms of the agreements made by debt and equity holders. . Conversions of debt to equity are made at book value. C. Debt forgiveness is recognized as a gain in earnings. 3. The debt and the assets would be removed from the books. A $1 50,000 gain on asset disposal and a $200,000 gain on debt restructure would be agonized to balance the entry. 4. In a comprehensive revaluation, all assets and liabilities are revalued to fair value, whether fair value is highe r or lower than book value. Retained earnings (if any) are reclassified; any debit balance of retained earnings is eliminated by reducing other equity accounts. Gains and losses go directly to retained earnings and by-pass earnings. Cases Case 15-1 Zebu Limited Overview Zebu Limited is a subsidiary of Holdings Limited, and complies with FIRS. The company has several transactions to complete for XX, and several financing options to consider for XX. The company must com ply with a current ratio and a total liabilities to tangible net worth ratio, as part of existing loan arrangements. There may be pressure to adopt accounting policies to achieve compliance; ethical behavior is important. Issues . Required adjustments 2. Statement of changes in equity 3. Covenant evaluation 4. Financing alternatives 5. Action re: covenant issues Analysis and conclusion 1. Required adjustments Retirement and conversion of the preferred shares and all stock option transactions are journalized in Exhibit 1 and revised draft SSP accounts are shown in Exhibit 2. These transactions are straight-forward and no reporting alternatives are available. The Zebu statement of changes in equity, in multi-column form, is shown in Exhibit 3. It is assumed that no dividends were declared during the year; if there were dividends, the earnings amount changes. Changes in retained earnings and accumulated OIC were entirely assumed to relate to comprehensive income for XX. Based on the xx revised financial statements in exhibit 2, the covenants are as follows: Covenant Limit Calculation (per exhibit 2) Rest It Current assets to current liabilities Not less than 0. 82 Total liabilities to tangible net worth Not greater than 1. 5:1 ($28,589 $5,500) 1 . 61 Zebu is out of line with the current ratio covenant, since 0. 82 is less than 1. They are also out of line on the total liabilities covenant, since 1 . 61 is greater than 1. 5. This situation must be addressed. Possible actions are explored in item 5, below. 4. Financing alternatives. The two financing alternatives are identical in terms of capital raised, term, and security. The alternatives are different in the following ways: 1 Alternative 1 has an interest cost of 4% while alternative 2 has an interest cost f 6%. This is a difference of SSL O million x 2% = $200,000 annually for ten year; assuming a tax rate of 40%, this is $1 20,000 of after-tax savings per year. 2. Alternative 1 allows the company to substitute shares for principal at maturity, eliminating $10 million of principal repayment at maturity if the company wishes. However, it also dilutes ownership, if this is an issue for existing shareholders. 3. Alternative 1 sets a share price of $20 per share for shares issued at maturity ($10 million/500,OHO shares). Based on the outstanding options, the companys share price seems to be in the range of 20; $30 options were allowed to lapse and new options were issued for $20. Therefore, the $20 used as a reference price in Alternative 1 seems to set the terms of the debt arrangement at current market prices. This must be attractive to investors, since the interest rate on Alternative 1 is lower than that for Alternative 2; Alternative 2 does not set a share price for conversion. 4. Alternative 1 would be accounted for as partially debt and partially equity while Alternative 2, since the share price is undetermined, is all debt. Alternative 1 would be split as follows: $10,000 Interest liability $7,025 Issuance price $200 PDP) 2,975 Equity component A discount rate of 3% has been used, looking at Alternative 2 with no equity component and a 6% rate (3% 6%/2).