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LESSON 4

Review material
Review questions
Question 1
Several financial instruments are described below. Classify each financial instrument as
debt, equity, or hybrid. Explain your reasoning.
A. Series A preference shares, annual 6 cumulative dividend, convertible into two
ordinary shares for every 100 preference share at the investors option, redeemable
at 110 per share at the companys option in 20X10.
B. Subordinated 8% debentures, interest payable semi-annually, and due in 20X7. At
maturity, the face value of the debentures may be converted, at the companys option,
into ordinary shares at a price of 12.50 per share.
C. Series B preference shares, annual 6 cumulative dividend, redeemable at the
investors option for 110 per share, plus dividends in arrears. The company may, at
its option, redeem the total obligation for preference shares in ordinary shares at
market values.
D. Subordinated debentures payable, bearing interest of 9%, with the interest rate reset
every three years by reference to market rates. Principal is to be repaid only on the
dissolution of the company, if ever. However, the company may choose to repay the
principal, at its option, on any interest re-pricing anniversary.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First Edition
(Toronto: McGraw-Hill Ryerson, 2000), Question P15-3, page 889. Adapted with
permission.

Question 2
Renouf Corporation issued 10-year convertible bonds in January 20X0. The bonds were
convertible to Renoufs ordinary shares at the investors option on maturity. The bonds
had a par value of 4 million and were issued for 4,300,000. Had the bonds not been
convertible, total proceeds to Renouf would only have been 3,900,000. On maturity,
one-half of the bonds were converted into 20,000 ordinary shares, as per the conversion
terms. The other half of the bonds were redeemed for cash at face value.

Required
a.
b.
c.
d.
e.

Explain why the convertible bonds are hybrid instruments.


Explain how the conversion option can be valued.
Provide the journal entry to record the financial instrument at issue.
Provide the journal entry to record the disposition of the bond at maturity.
Why is it unusual to have part of a bond issue convert and part paid out in cash on the
same date?

Financial Accounting: Liabilities & Equities

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Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First Edition
(Toronto: McGraw-Hill Ryerson, 2000), Question E15-4, page 885. Adapted with
permission.

Question 3
Miner Manufacturing Company (MMC) issued 300,000, 5%, five-year bonds at par.
The bonds pay interest annually at year end. At maturity, the bonds can be repaid in cash
or converted to 60,000 ordinary shares at MMCs option. Market interest rates were 6%
at the time the bond was issued.

Required
a. Calculate the portion of the bond relating to principal and to interest.
b. Provide the entry to record the issuance of the bond.
c. Provide the entries to record the interest expense and the annual payment for each of
the five years.
d. Provide the entries to record the charge to retained earnings each year for five years.
e. Provide the entry to record the maturity of the bond, assuming the shares were issued.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First Edition
(Toronto: McGraw-Hill Ryerson, 2000), Question E15-5, page 885. Adapted with
permission.

Question 4
Pan-Canadian Airline (PCA) is a public company, and one of Canadas largest domestic
airlines. Worldwide, airlines have experienced tough times since 20X1, and PCA is no
exception. It has posted significant losses the past few years. Factors such as the
recession of the late 1990s, industry deregulation in the United States, price wars started
by financially distressed competitors, and reduced spending for business and personal
travel following 9/11 have all been cited as the cause of woes in the air travel industry.
Amalgamation and bankruptcy among major carriers has become commonplace.
At its most recent fiscal year end, PCA reported 4 billion in assets, of which 60% is
equipment, primarily aircraft. Financing is provided by short-term borrowings (15%),
long-term borrowings (45%), subordinated perpetual borrowings (17%), and
shareholders equity (23%). Subordinated perpetual borrowings are disclosed as a
separate classification on the balance sheet, between long-term borrowings and
shareholders equity. It is described in the notes as shown here:
(amounts in millions):
Subordinated perpetual debt at 8.55% for five years.
Callable at PCAs option every five years at par.

680

The maturity of the subordinated is debt is only on the liquidation, if ever, of PCA.
Interest rates are set every five years based on five-year comparable debt issues. The
company may call the debt every five years. The borrowings must be redeemed if certain
dividend limitations are violated, or if interest is in arrears. Principal and interest
payments on the borrowings are unsecured and are subordinated to the prior payment in
full of all indebtedness for borrowed money. It is not probable that circumstances will
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Financial Accounting: Liabilities & Equities

arise requiring redemption of the borrowings. It is not probable that PCA will call the
borrowings.
You work in the special projects section of the controllers office of a major financial
institution. Your corporate lending division is considering granting a long-term secured
loan to PCA; part of the lending decision involves ratio analysis, including various
debt-to-equity ratios. The lending decision will be based on projected cash flow and
interest coverage, and the risk involved. Bank analysts disagree among themselves as to
whether to include the subordinated perpetual borrowings as debt or equity in ratio
analysis, a decision that is independent of its financial statement classification. You have
been consulted and asked to write a brief report that provides an analysis of the two
alternatives and a recommendation.

Required
Prepare the required report.

Financial Accounting: Liabilities & Equities

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Review solutions
Question 1
Item A
Equity

The preference shares are convertible into ordinary shares another equity
item; this feature does not make the preference shares anything other than
equity. The fact that the preference shares are convertible into ordinary shares
does not create a financial liability. There is no obligation to transfer cash or
another financial asset. Note also that although the shares can be redeemed at
the option of the company, they do not have to be redeemed, and thus are not
a liability. Dividend claims are not a liability.

Item B
Hybrid

The interest portion of the bond legally has to be paid and thus is a liability of
the company. The principal does not have to be repaid, but can be
extinguished through the issuance of ordinary shares at the option of the
company. This is an equity interest. The proceeds on issuance would be
divided between the unavoidable interest obligation and the equity principal
portion.

Item C
Equity

Redeemable shares that are redeemable at the investors option in cash would
normally be classified as a liability. Dividends in arrears, where the investors
have the ability to legally force payment, would also be a liability. However,
in this case, the company can extinguish all obligations for the preference
shares and any dividends in arrears, through the issuance of ordinary shares,
an equity interest. No cash payment can be forced. Thus, the preference shares
are entirely equity.

Item D
Debt

This is perpetual debt. The annual interest obligation is a liability, as the


company has to pay cash annually. The principal looks like equity, as it only
has to be paid on dissolution of the company or at the companys option.
However, this indefinite payment has a present value of zero because its
payment date is infinite: it is not recognized. All that is left is the interest
obligation, and the financial instrument is recorded purely as a liability.

Question 2
a.
Convertible bonds are hybrid instruments in that they have some characteristics of debt
(guaranteed interest payments, minimum cash payout at maturity) and some
characteristics of equity (ability to participate in residual interest in net assets).

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Financial Accounting: Liabilities & Equities

b.
The conversion option can be valued by determining the present value of the bond
component, with the residual proceeds allocated to the option: 400,000 (4,300,000
3,900,000) in this case.
c.
Cash........................................................................................
Discount on bonds payable....................................................
Bonds payable..................................................................
Ordinary stock conversion rights.....................................

4,300,000
100,000
4,000,000
400,000

d.
Bonds payable........................................................................
Ordinary stock conversion rights...........................................
Contributed capital, lapse of rights..................................
Ordinary stock (2,000,000 + 200,000)...........................
Cash..................................................................................

4,000,000
400,000
200,000
2,200,000
2,000,000

e.
A split is unusual because it is usually a better deal to take either the stock (in which case
all holders will convert), or the money (in which case all bondholders will cash out).

Question 3
a.
Principal
Interest payments
Bond price

300,000 (PVIF, 6%, 5) (0.74726) =


(300,000 6%) (PVIFA, 6%, 5) (4.21236) =

224,178
75,822
300,000

b.
Cash........................................................................................
Interest liability on bond..................................................
Share equity bond.......................................................

300,000
75,822
224,178

c.
Interest table (not required)

Year
1
2
3
4
5

Beginning
balance
Interest
Interest Liability @6%
75,822
62,371
48,113
33,000
16,980

4,549
3,742
2,887
1,980
1,020*

Financial Accounting: Liabilities & Equities

Payment

Ending
Interest
Liability

18,000
18,000
18,000
18,000
18,000

62,371
48,113
33,000
16,980
0
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* Rounded
Year 1
Interest expense......................................................................
Interest liability on bond..................................................
Interest liability on bond........................................................
Cash..................................................................................
Year 2
Interest expense......................................................................
Interest liability on bond..................................................
Interest liability on bond........................................................
Cash..................................................................................
Year 3
Interest expense......................................................................
Interest liability on bond..................................................
Interest liability on bond........................................................
Cash..................................................................................
Year 4
Interest expense......................................................................
Interest liability on bond..................................................
Interest liability on bond........................................................
Cash..................................................................................
Year 5
Interest expense......................................................................
Interest liability on bond..................................................
Interest liability on bond........................................................
Cash..................................................................................

4,549
4,549
18,000
18,000
3,742
3,742
18,000
18,000
2,887
2,887
18,000
18,000
1,980
1,980
18,000
18,000
1,020
1,020
18,000
18,000

d.
Year 1
Retained earnings (224,178 6%).......................................
Share equity bond.......................................................

13,451

Year 2
Retained earnings [(224,178 + 13,451 = 237,629) 6%]
Share equity bond.......................................................

14,258

Year 3
Retained earnings [(237,629 + 14,258 = 251,887) 6%]
Share equity bond.......................................................

15,113

13,451

14,258

15,113

Year 4
Retained earnings [(251,887 + 15,113 = 267,000) 6%]16,020
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Financial Accounting: Liabilities & Equities

Share equity bond.......................................................


Year 5
Retained earnings [(267,000 + 16,020 = 283,020) 6%]*
Share equity bond.......................................................
* Rounded

16,020
16,980
16,980

e.
Share equity bond (283,020 + 16,980).........................
Ordinary shares................................................................

300,000
300,000

Question 4
Overview
Pan-Canadian Airline (PCA) is a public company that has recently posted large losses.
The airline industry in general is often in financial distress. PCA has significant assets
and long-term debt. Reducing debt and improving profitability and/or interest coverage
would be prime corporate (reporting) objectives. This analysis is from the perspective of
a chartered bank making a lending decision, concerned about risk profile and cash flow.
The bank has an ethical responsibility to make careful investing decisions that affect its
shareholders capital; it also has an ethical responsibility to fairly assess PCAs
obligations. The task is simply to discern the classification that makes the most sense for
this one purpose.
Issues and analysis
Paragraph 49(b) of the IASB Framework defines a liability as
a present obligation of the entity arising from past events, the settlement of which is expected to result
in an outflow from the entity of resources embodying economic benefits.

Paragraph 11 of IAS 32 defines a financial liability as


a contractual obligation to deliver cash or another financial asset to
another entity, or to exchange financial assets or financial liabilities with
another entity under conditions that are potentially unfavourable to the
entity, or under specific circumstances, a contract that will or may be
settled in the entitys own equity instruments.
Paragraph 11 of IAS 32 defines an equity instrument as
any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.
The following discussion will focus on the establishment of a maturity date, the certainty
of returns, and the debts priority.
The perpetual debt might be considered equity since there is no due date and, like equity,
capital is only returned if the company is liquidated. Payments are subordinated to the
payment of other debt and are unsecured. Redemption or call of the debt has been judged
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unlikely. Perpetual debt is more like preference shares in that perpetual debt is often
issued when equity is desirable, but there is a legal barrier to issuing equity.
On the other hand, this type of financial instrument does not involve a residual (that is,
risky or variable) interest in assets. The payout amount, and especially the annual
interest, is contractually required. Therefore, it does not meet the substance of an equity
definition.
One could argue that this is clearly debt: legally, it is structured as debt, risk of interest
rate fluctuations is limited to successive five-year terms, and the principal would have to
be repaid if dividend restrictions or interest payments are not met. Interest obligations, a
legal liability, are clearly debt. For financial reporting purposes, standard-setters have
decided that perpetual debt is to be classified as a liability: it is an agreement to deliver
cash at specific points in time.
Keep in mind that PCA is a company with significant recent losses and is in a very
volatile industry.
The classification decision is being made from the perspective of a bank making a loan to
a fairly risky company and industry. Given the risks involved, the debt arguments seem
even stronger. Year by year, the interest charges place this obligation as debt. It is only
on repayment that things get out of focus. Yearly cash flow and interest coverage are
important factors, and PCA definitely has a fixed obligation to these investors.
Recommendation
The perpetual debt should be classified as long-term debt for analysis purposes. This
decision is based on the risk in PCAs business environment and the fact that perpetual
debt requires annual maintenance payments.

Sample marking key


Note:
This sample marking key is provided to give you an indication of how the marker will evaluate your case
assignments. Keep in mind that there is no one right answer to a case and that the marking key is not a
complete solution. The key provides for more than the maximum mark allocation. You are not expected to
cover all the points.

Overview
Company is operating in a very risky, volatile industry. (1)
Company has had recent losses. (1)
Company has a lot of long-term debt and likely many covenants. (1)
Company is sensitive to debt-to-equity and interest coverage issues. (1)
Perspective is non-GAAP; that of a banker. (1)
Bank has ethical responsibilities. (1)

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Financial Accounting: Liabilities & Equities

Maximum 3
Issues/Alternatives
Classification of debt (1/2)
Maximum 1/2
Analysis
Debt definition from the IASB Framework (1)
Debt and equity definition from financial instruments (1)
Criteria established: maturity, return, priority (1)
Perpetual debt as equity
Pro:

Con:

Item has no due date. (1)


Capital is only paid on liquidation or default. (1)
Security is subordinated. (1)
Redemption is not likely. (1)
There is no residual or risky interest in assets. (1)
Principal and return are contractually fixed. (1)
Financial instruments definition is not met for principal. (1)

Perpetual debt as debt


Pro:

Con:

Instrument is legally described as debt. (1)

Return is guaranteed. (1)

Interest must be paid. (1)

Interest is set every five years; there is no risk to the investor. (1)

Redemption is possible since the industry is risky. (1)


There is no principal repayment. (1)

Overall
Bank perspective is that of a lender to a risky company. (1)
Perpetual debt must have interest repaid annually. (1)
Key features are closer to debt than equity. (1)
Other valid points not mentioned (1 mark each)
Maximum 15
Recommendation
A sensible recommendation, consistent with analysis
0 for no recommendation or illogical recommendation
1 for a weak recommendation
2 for an intelligent recommendation
Maximum 2

Financial Accounting: Liabilities & Equities

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Communication
Organization, quality of expression
0 for unacceptable communication skills
1 for weak communication skills
2 for acceptable communication skills
Maximum 2
Overall
maximum 20

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Financial Accounting: Liabilities & Equities