lecture

• Dilutive securities


  Financial instruments that enable their holders to obtain ordinary shares and reduce (dilute) earnings per share (EPS) by increasing the number of shares outstanding, if converted or exercised

  
• Examples of dilutive securities

  • Convertible Bonds
  • Convertible Preference Shares
  • Warrants
  • Employee Share Options
• Equity investments


  Ownership interest, such as ordinary, preference, or other capital shares
• Basic EPS


  How much income is earned by each ordinary share
• Equity investments


  Rights to acquire or dispose of ownership interests at an agreed-upon or determinable price (e.g., warrants and rights)
• Initial recognition of equity investments

  1. Recognized at cost using the purchase price

  2. Broker's commissions and fees are recorded as expenses
• Equity investments

  • The degree to which one company (investor) acquires an interest in ordinary shares of another company (investee) generally determines the accounting treatment for the investment after the acquisition
• Diluted EPS


  How much income is earned by each ordinary share if we include all potentially converted ordinary shares
• Antidilutive securities


  Securities that would increase EPS if exercised or converted, and are generally not considered in diluted EPS

  
• Equity investment classifications based on percentage of voting shares held

  • Holdings of Less Than 20%
  • Holdings of 20% - 50%
  • Holdings of > 50%
• Debt investments

  Loans, bonds
• Convertible bonds


  Bonds that can be changed into equity shares (or other corporate securities)
• Holdings of Less Than 20% (under IFRS)


  The presumption is that equity investments are held for trading (i.e., to profit from price changes)
• Equity investments


  Ordinary shares, preference shares
• Reasons to invest in convertible bonds

  • Benefit of a bond (guaranteed interest and principal)
  • Exchangeable for shares (call option)
• Main motivations for investing in other entities' securities

  • Earn a return (e.g., interest, dividends, capital gains)
  • Strategic investment to secure certain operating or financing arrangements with another company (e.g., control a supplier)
• IFRS 9 classification of financial assets

  • Amortized cost
  • Fair value
• IFRS 9 classification criteria

  1. Business model test

  2. Contractual cash flow characteristics test (SPPI test)
• Accounting for equity investments held for trading (FVPL)


  1. Investments are valued at fair value

  2. Record unrealized gains and losses in net income (FVPL), using Fair Value Adjustment as a valuation account

  3. Gains and losses are reported as part of other income and expenses on the income statement

  4. Cash dividends are recorded as dividend revenue

  
• Amortized (historical) cost

  Assets/liabilities reported at original value (adjusted for depreciation/amortization)
• Fair value


  Amount for which an asset could be exchanged between knowledgeable willing parties in an arm's length transaction (i.e., in an open market)
• Mark-to-market


  Measuring fair value using the market price for actively traded assets on a liquid market
• Mark-to-model


  Measuring fair value using a valuation model (e.g., Black-Scholes model for the estimation of the fair value of employee stock options)
• Reasons to issue convertible bonds


  • Obtain debt financing at cheaper rates
  • Raise equity capital with less dilution of ownership control
• Downsides of fair value accounting include uncertainty in measurement, more judgment and subjective estimates required by managers, and potential bias in information
• Republic SA's equity investments held for trading

  • Purchased ordinary shares of three companies, each investment representing less than a 20% interest
  • Received a cash dividend of €4,200 on its investment in the ordinary shares of Nestlé
  • Recorded a decrease in fair value and a loss at December 31, 2022
  • Sold all of its Burberry ordinary shares, receiving €287,220
  • Purchased €255,000 of Continental Trucking ordinary shares (20,000 shares, €12.75 per share), plus brokerage commissions of €1,850
• Fair value accounting was heavily debated after the banking crisis, with some arguing it intensified the crisis by requiring recognition of unrealized losses
• Held-for-collection (Held-until-Maturity)


  Business model where the objective is to hold the debt investment to collect contractual cash flows
• Twitter Inc. issued a convertible bond with a face value of $1 billion at an interest rate of 0.25%, due in 2024.
• Income statement effects for Republic SA's equity investments held for trading in 2022 and 2023

  
• Held-for-collection and selling


  Business model where the objective is to both collect contractual cash flows and sell the debt investment
• Some market commentators suggest Netflix Inc. could finance its new productions by issuing convertible bonds instead of regular bonds to save on interest costs and reduce dilutive effect of a normal equity raise.
• Equity investments (FVOCI)


  • IFRS allows companies to classify some (strategic) equity investments < 20% as non-trading
  • The decision is irrevocable
  • Unrealized gains and losses are recorded in other comprehensive income (FVOCI)

  
• Trading


  Business model where the objective is to sell the debt investment
• Compound financial instrument


  Convertible bonds have both debt and equity components
• Accounting for debt investments at amortized cost

  1. Record investment at purchase price

  2. Accrue interest revenue using effective interest method

  3. Amortize any premium or discount
• Equity investments (Holdings: 20% - 50%)


  • An investment (direct or indirect) of 20% or more of the voting shares of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence, but not control, over an investee
  • The investor must account for the investment using the equity method

  
• Applying the "with-and-without" approach to value convertible bonds

  1. Determine the total fair value of convertible debt

  2. Determine the liability component by computing the net present value of all future cash flows

  3. Subtract the liability component from the total fair value to get the equity component

  
• Accounting for debt investments held-for-collection and selling (HFCS)

  1. Record investment at purchase price and accrue interest revenue using effective interest method during the reporting period

  2. At the end of the year, adjust the amortized cost to fair value with the unrealized holding gain/loss reported in other comprehensive income (OCI)

  
• Equity investments (Holdings: > 50%)


  • When one company acquires a voting interest of more than 50% in another company, it usually has control over the acquired company
  • The investor is then referred to as the parent
  • The investee is then referred to as the subsidiary
  • Investment in the subsidiary is reported on the parent's books as equity investment
  • Parent generally has to prepare consolidated financial statements