Question:
[A] Aon Corporation’s Mezzanine Preferred Stock In its 2002 annual report to shareholders, Aon Corporation described its mandatorily redeemable preferred stock as follows: In January 1997, Aon created Aon Capital A, a wholly-owned statutory business trust, for the purpose of issuing mandatorily redeemable preferred capital securities (Capital Securities). The sole asset of Aon Capital A is $726 million aggregate principal amount of Aon’s 8.205% Junior Subordinated Deferrable Interest Debentures due January 1, 2027. Aon Capital A issued $800 million of 8.205% (mandatorily redeemable preferred) Capital Securities in January 1997. The Capital Securities are subject to mandatory redemption on January 1, 2027 or are redeemable in whole, but not in part, at the option of Aon upon the occurrence of certain events. . . . During 2002, approximately $98 million of the Capital Securities were repurchased on the open market for $87 million, excluding accrued interest. . . . Aon’s 2002 balance sheet showed the following amounts:
![[A] Aon Corporation’s Mezzanine Preferred Stock In its 2002 annual report to shareholders, Aon Corporation described its mandatorily redeemable preferred stock as follows: In January 1997, Aon created Aon Capital A, a wholly-owned statutory business trust, for the purpose of issuing mandatorily redeemable preferred capital securities (Capital Securities). The sole asset of Aon Capital A is $726 million aggregate principal amount of Aon’s 8.205% Junior Subordinated Deferrable Interest Debentures due January 1, 2027. Aon Capital A issued $800 million of 8.205% (mandatorily redeemable preferred) Capital Securities in January 1997. The Capital Securities are subject to mandatory redemption on January 1, 2027 or are redeemable in whole, but not in part, at the option of Aon upon the occurrence of certain events. . . . During 2002, approximately $98 million of the Capital Securities were repurchased on the open market for $87 million, excluding accrued interest. . . . Aon’s 2002 balance sheet showed the following amounts:
Required:
1. Aon’s capital securities are forms of preferred stock. Assume that Aon Capital A (the trustee) issued the preferred shares on January 1, 1997, for $800 million cash, the same day that Aon Corporation issued $800 million of its junior debentures to the trust.
Describe the cash flows associated with these two transactions—that is, explain who received cash and who gave up cash in each case.
2. One year later (on December 31, 1997), Aon Corporation must pay 8.205% interest to debt holders, and Aon Capital A must pay an 8.205% dividend to preferred stockholders.
Describe the cash flows associated with each of these payments—that is, explain who received cash, who gave up cash, and how much cash was exchanged.
3. Why did Aon Corporation create Aon Capital A?
4. For financial reporting purposes, Aon Corporation will issue consolidated financial statements that include the activities of Aon Capital A. In addition, GAAP at the time did not
require liability treatment of mandatorily redeemable preferred stock. How did Aon Corporation show its cash interest payment on December 31, 1997?
5. Why does Aon Corporation’s 2002 balance sheet show the Capital Securities in the “mezzanine” section between total liabilities and stockholders’ equity?
6. Aon Corporation is an insurance company, so most of its liabilities relate to insurance policy premiums and policy liabilities. The company’s debt includes Short-term borrowings and Notes payable. Compute Aon’s debt-to-equity ratio for 2002 assuming that the Capital Securities are treated as part of equity. Repeat the calculation, this time assuming that the Capital Securities are part of debt. Which debt-to-equity ratio provides the most accurate measure of the company’s true debt and equity position? Why?
[B] Cephalon Inc.’s Zero-Coupon, Zero Yield-to-Maturity Convertible Notes
Cephalon Inc. issued $750 million of zero-coupon convertible notes. Because the notes were issued at par, meaning that Cephalon received $750 million cash for the notes, they have a zero yield-to-maturity. Settlement in cash upon conversion is not permitted. Here is what Cephalon said about the notes:
We issued and sold in a private placement $750.0 million of Zero Coupon Convertible Subordinated Notes (the “Notes”). The interest rate on the Notes is zero and the Notes will not accrete interest. . . . The Notes are subordinate to our existing and future senior indebtedness. The Notes were issued in two tranches and have the following salient terms:
∙ $375.0 million of Zero Coupon Convertible Subordinated Notes due June 15, 2023 . . . are convertible prior to maturity, subject to certain conditions described below, into shares of our common stock at a conversion price of $59.50 per share (a conversion rate of approximately 16.8067 shares per $1,000 principal amount of notes). . . . The Notes also contain a restricted convertibility feature that does not affect the conversion price of the notes but, instead, places restrictions on a holder’s ability to convert their notes into shares of our common stock (“conversion shares”). A holder may convert the notes if one or more of the following conditions
is satisfied:
if, on the trading day prior to the date of surrender, the closing sale price of our common stock is more than 120% of the applicable conversion price per share (the “conversion price premium”);
if we have called the notes for redemption;
if the average trading prices of the notes for a specified period is less than 100% of the average of the conversion values of the notes during that period . . . ;
if we make certain significant distributions to our holders of common stock or we enter into specified corporate transactions.
Because of the inclusion of the restricted convertibility feature of the Notes, our diluted income per common share calculation does not give effect to the dilution from the conversion of the Notes until our share price exceeds the 20% conversion price premium or one of the other conditions above is satisfied.
Required:
Source: 10-Q filing for Cephalon Inc., June 2003.
1. Cephalon is a U.S. Company. What accounting entry did Cephalon make to record the
$750 million proceeds received from issuing the notes? Over the next year, what other
accounting entries (if any) related to these notes did the company make?
2. The notes mature in 2023, approximately 20 years from the date they were issued. At a
6% rate of annual interest, the present value of $1,000 to be received 20 years from today is only $311.805. (You might want to verify this conclusion.) Suppose that Cephalon’s true cost of borrowing money is 6% per year. How much did note holders pay for Cephalon debt, and how much did they pay for the option to convert the notes into shares of common stock?
3. Suppose that Cephalon separated the notes into debt and equity components and then
recorded each component separately. What accounting entry would the company make on the issue date to record the proceeds received from issuing the notes? Over the next year, what other accounting entries (if any) related to these notes would the company make?
4. Describe Cephalon’s financial reporting advantages of issuing zero-coupon, zero yield-to-maturity notes rather than a more traditional debt instrument. Why aren’t the notes included in the company’s computation of diluted earnings per share?
5. If Cephalon were to issue those same notes today, would it still be able to use the accounting
entries outlined in your answer to requirement 1?
[C] Avenet’s Cash Settled Convertible Debt
Avenet Inc., a U.S. company, is a global provider of electronic parts, enterprise computing and
storage products, and supply chain and logistics services for the electronic components industry.
The company’s 2009 annual report contained the following note:
The Financial Accounting Standards Board issued authoritative guidance which requires the
issuer of certain convertible debt instruments that may be settled in cash (or other assets) on
conversion to separately account for the debt and equity (conversion option) components of the instrument. The standard requires the convertible debt to be recognized at the present value of its cash flows discounted using the non-convertible debt borrowing rate at the date of issuance.
The resulting debt discount from this present value calculation is to be recognized as the value of the equity component and recorded to additional paid in capital. The discounted convertible debt is then required to be accreted up to its face value and recorded as non-cash interest expense over the expected life of the convertible debt.
1. At the time this authoritative guidance was issued, Avenet had already issued $300 million of 2% Convertible Senior Debentures due in 2034. The debentures were issued at par several years earlier, and thus Avenet received the full $300 million cash at the issue date. What journal entry did Avenet make at the time to record the convertible debt issuance? How much interest expense would Avenet record each year?
2. Under the approach now required by GAAP for cash-settled convertible debt, Avenet says the debt discount to be recorded at the issue date would have been $50 million and that the nonconvertible debt borrowing rate at the date of issuance would have been 7%. What journal entry would Avenet make to record the convertible debt issuance under current GAAP? How much interest expense would Avenet record during the first full year?
3. If Avenet followed IFRS guidance rather than U.S. GAAP, which of the two accounting treatments would the company have used at the issue date?
4. Avenet decided to extinguish its 2% Convertible Subordinate Debentures just prior to adopting the new U.S. GAAP guidance (described above) for cash settled convertible debt. Why did the company decide to retire the debt early?](../images/a-aon-corporations-mezzanine-preferred-stock-in-its-2002-annual-95131-1.jpg)
Required:
1. Aon’s capital securities are forms of preferred stock. Assume that Aon Capital A (the trustee) issued the preferred shares on January 1, 1997, for $800 million cash, the same day that Aon Corporation issued $800 million of its junior debentures to the trust.
Describe the cash flows associated with these two transactions—that is, explain who received cash and who gave up cash in each case.
2. One year later (on December 31, 1997), Aon Corporation must pay 8.205% interest to debt holders, and Aon Capital A must pay an 8.205% dividend to preferred stockholders.
Describe the cash flows associated with each of these payments—that is, explain who received cash, who gave up cash, and how much cash was exchanged.
3. Why did Aon Corporation create Aon Capital A?
4. For financial reporting purposes, Aon Corporation will issue consolidated financial statements that include the activities of Aon Capital A. In addition, GAAP at the time did not
require liability treatment of mandatorily redeemable preferred stock. How did Aon Corporation show its cash interest payment on December 31, 1997?
5. Why does Aon Corporation’s 2002 balance sheet show the Capital Securities in the “mezzanine†section between total liabilities and stockholders’ equity?
6. Aon Corporation is an insurance company, so most of its liabilities relate to insurance policy premiums and policy liabilities. The company’s debt includes Short-term borrowings and Notes payable. Compute Aon’s debt-to-equity ratio for 2002 assuming that the Capital Securities are treated as part of equity. Repeat the calculation, this time assuming that the Capital Securities are part of debt. Which debt-to-equity ratio provides the most accurate measure of the company’s true debt and equity position? Why?
[B] Cephalon Inc.’s Zero-Coupon, Zero Yield-to-Maturity Convertible Notes
Cephalon Inc. issued $750 million of zero-coupon convertible notes. Because the notes were issued at par, meaning that Cephalon received $750 million cash for the notes, they have a zero yield-to-maturity. Settlement in cash upon conversion is not permitted. Here is what Cephalon said about the notes:
We issued and sold in a private placement $750.0 million of Zero Coupon Convertible Subordinated Notes (the “Notesâ€). The interest rate on the Notes is zero and the Notes will not accrete interest. . . . The Notes are subordinate to our existing and future senior indebtedness. The Notes were issued in two tranches and have the following salient terms:
∙ $375.0 million of Zero Coupon Convertible Subordinated Notes due June 15, 2023 . . . are convertible prior to maturity, subject to certain conditions described below, into shares of our common stock at a conversion price of $59.50 per share (a conversion rate of approximately 16.8067 shares per $1,000 principal amount of notes). . . . The Notes also contain a restricted convertibility feature that does not affect the conversion price of the notes but, instead, places restrictions on a holder’s ability to convert their notes into shares of our common stock (“conversion sharesâ€). A holder may convert the notes if one or more of the following conditions
is satisfied:
if, on the trading day prior to the date of surrender, the closing sale price of our common stock is more than 120% of the applicable conversion price per share (the “conversion price premiumâ€);
if we have called the notes for redemption;
if the average trading prices of the notes for a specified period is less than 100% of the average of the conversion values of the notes during that period . . . ;
if we make certain significant distributions to our holders of common stock or we enter into specified corporate transactions.
Because of the inclusion of the restricted convertibility feature of the Notes, our diluted income per common share calculation does not give effect to the dilution from the conversion of the Notes until our share price exceeds the 20% conversion price premium or one of the other conditions above is satisfied.
Required:
Source: 10-Q filing for Cephalon Inc., June 2003.
1. Cephalon is a U.S. Company. What accounting entry did Cephalon make to record the
$750 million proceeds received from issuing the notes? Over the next year, what other
accounting entries (if any) related to these notes did the company make?
2. The notes mature in 2023, approximately 20 years from the date they were issued. At a
6% rate of annual interest, the present value of $1,000 to be received 20 years from today is only $311.805. (You might want to verify this conclusion.) Suppose that Cephalon’s true cost of borrowing money is 6% per year. How much did note holders pay for Cephalon debt, and how much did they pay for the option to convert the notes into shares of common stock?
3. Suppose that Cephalon separated the notes into debt and equity components and then
recorded each component separately. What accounting entry would the company make on the issue date to record the proceeds received from issuing the notes? Over the next year, what other accounting entries (if any) related to these notes would the company make?
4. Describe Cephalon’s financial reporting advantages of issuing zero-coupon, zero yield-to-maturity notes rather than a more traditional debt instrument. Why aren’t the notes included in the company’s computation of diluted earnings per share?
5. If Cephalon were to issue those same notes today, would it still be able to use the accounting
entries outlined in your answer to requirement 1?
[C] Avenet’s Cash Settled Convertible Debt
Avenet Inc., a U.S. company, is a global provider of electronic parts, enterprise computing and
storage products, and supply chain and logistics services for the electronic components industry.
The company’s 2009 annual report contained the following note:
The Financial Accounting Standards Board issued authoritative guidance which requires the
issuer of certain convertible debt instruments that may be settled in cash (or other assets) on
conversion to separately account for the debt and equity (conversion option) components of the instrument. The standard requires the convertible debt to be recognized at the present value of its cash flows discounted using the non-convertible debt borrowing rate at the date of issuance.
The resulting debt discount from this present value calculation is to be recognized as the value of the equity component and recorded to additional paid in capital. The discounted convertible debt is then required to be accreted up to its face value and recorded as non-cash interest expense over the expected life of the convertible debt.
1. At the time this authoritative guidance was issued, Avenet had already issued $300 million of 2% Convertible Senior Debentures due in 2034. The debentures were issued at par several years earlier, and thus Avenet received the full $300 million cash at the issue date. What journal entry did Avenet make at the time to record the convertible debt issuance? How much interest expense would Avenet record each year?
2. Under the approach now required by GAAP for cash-settled convertible debt, Avenet says the debt discount to be recorded at the issue date would have been $50 million and that the nonconvertible debt borrowing rate at the date of issuance would have been 7%. What journal entry would Avenet make to record the convertible debt issuance under current GAAP? How much interest expense would Avenet record during the first full year?
3. If Avenet followed IFRS guidance rather than U.S. GAAP, which of the two accounting treatments would the company have used at the issue date?
4. Avenet decided to extinguish its 2% Convertible Subordinate Debentures just prior to adopting the new U.S. GAAP guidance (described above) for cash settled convertible debt. Why did the company decide to retire the debt early?
Transcribed Image Text:
($ millions) Liabilities and Stockholders' Equity 2002 2001 Insurance premiums payable Insurance policy liabilities General liabilities $ 9,904 5,310 $ 8,233 4,990 General expenses Short-term borrowings Notes payable 2,012 117 1,770 257 1,671 1,673 1,694 1,071 Other liabilities Total Liabilities 20,687 18,015 Redeemable Preferred Stock 50 50 Mandatorily Redeemable Preferred Capital Securities Total Common Stockholders' Equity 702 800 3,895 3,465
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> Stone has provided the following information on its available-for-sale securities: Aggregate cost as of 12/31/17 …………………..$170,000 Unrealized gain as of 12/31/17 …………………..4,000 Unrealized losses as of 12/31/17 …………………..26,000 Net realized gains during
> On September 1, 2017, Cano & Company, a U.S. corporation, sold merchandise to a foreign firm for 250,000 euros. Terms of the sale require payment in euros on February 1, 2018. On September 1, 2017, the spot exchange rate was $1.30 per euro. At Cano’s yea
> Sea Company purchased 60% of Island Company’s common stock for $180,000. On the acquisition date, Island’s book value of net assets totaled $250,000 and the fair value of identifiable net assets totaled $275,000. The $
> The following data pertain to Tyne Company’s investments in marketable equity securities. (Assume that all securities were held throughout 2016 and 2017.) Required: 1. What amount should Tyne report as unrealized holding gain (loss) i
> Several years ago, RJR Nabisco Holdings Corporation (Holdings) offered for sale 93 million shares of its subsidiary RN-Nabisco Group. According to the prospectus, the estimated initial public offering price for RN-Nabisco common stock would be in the ran
> On December 31, 2017, the Stockholders’ Equity section of Mercedes Corporation was as follows: Common stock, par value $5; authorized 30,000 shares; ………… $ 45,000 issued and outstanding, 9,000 shares Additional paid-in capital …………………………………………………… 58,00
> Newton Corporation was organized on January 1, 2017. On that date, it issued 200,000 shares of its $10 par-value common stock at $15 per share (400,000 shares were authorized). During the period from January 1, 2017, through December 31, 2019, Newton rep
> Weldon Wire has issued 2,500,000 shares of $2 par common stock at an average price of $10 per share. Of these, 100,000 shares were repurchased during the year for $15 each and retired. Another 200,000 shares of the shares were repurchased for $17 each an
> Munn Corporation’s records included the following stockholders’ equity accounts: Preferred stock, par value $15, authorized 20,000 shares …………………… $255,000 Additional paid-in capital—preferred stock ………………………………………… 15,000 Common stock, no par, $5 stated
> Warren Corporation was organized on January 1, 2017, with an authorization of 500,000 shares of common stock ($5 par value per share). During 2017, the company had the following capital transactions: January 5 ………… Issued 100,000 shares at $5 per share A
> On July 1, 2017, Amos Corporation granted nontransferable, nonqualified stock options to certain key employees as additional compensation. The options permit the purchase of 20,000 shares of Amos’s $1 par common stock at a price of $32 per share. On the
> Information concerning the capital structure of the Petrock Corporation is as follows: During 2017, Petrock paid dividends of $1 per share on its common stock and $2.40 per share on its preferred stock. The preferred stock is convertible into 20,000 sha
> Tam Company’s net income for the year ending December 31, 2017, was $10,000. During the year, Tam declared and paid $1,000 cash dividends on preferred stock and $1,750 cash dividends on common stock. At December 31, 2017, the company had 12,000 shares of
> On January 1, 2017, Cello Co. established a defined benefit pension plan for its employees. At January 1, 2017, Cello estimated the service cost for 2017 to be $45,000. At January 1, 2018, it estimated 2018 service cost to be $49,000. On the plan incepti
> George Corporation has a defined benefit pension plan for its employees. The following information is available for 2017: PBO at 1/1 ………………………………………… $930,000 Payments made to retirees at 12/31 ………… 204,000 Service cost ………………………………………… 196,000 Actua
> Starbucks Corp., the passionate purveyors of coffee and everything else that goes with a full and rewarding coffeehouse experience, included the following table in its 2009 annual report: Total stock based compensation and ESPP expense recognized in the
> At January 1, 2017, Archer Co.’s PBO is $500,000 and the fair value of its pension plan assets is $630,000. The average remaining service period of Archer’s employees is 12 years. The AOCI—net actuari
> At January 1, 2017, Milo Co.’s projected benefit obligation is $300,000, and the fair value of its pension plan assets is $340,000. The average remaining service period of Milo’s employees is 10 years. Milo Co. uses th
> Bonny Corp. has a defined benefit pension plan for its employees who have an average remaining service life of 10 years. The following information is available for 2016 and 2017 related to the pension plan: Bonny Corp. had no beginning balance in its AO
> Zeff Manufacturing provides the following information about its postretirement health care plan for 2017: Accumulated postretirement benefit obligation on 1/1 ………… $300,000 Fair value of plan assets on 1/1 ………………………………………… 30,000 Benefits paid to retiree
> Jones Company has a postretirement benefit (health care) plan for its employees. On January 1, 2017, the balance in the Accumulated postretirement benefit obligation account was $300 million. The assumed discount rate—for purposes of determining postreti
> Cummings Inc. had the following reconciliation at December 31, 2017: Fair value of plan assets …………………………. $5,000 PBO …………………….………………………………. 4,200 Funded status …………………….………………. $ 800 AOCI—prior service cost ………………………. $ 300 AOCI—net actuarial loss …………
> Neighborhood Supermarkets is preparing to go public, and you are asked to assist the firm by preparing its statement of cash flows for 2017. Neighborhood’s balance sheets at December 31, 2016, and December 31, 2017, and its income state
> The Barden Corporation’s comparative balance sheets for 2017 and 2016 are presented below. The income statement of Barden Corporation for the year ended December 31, 2017, is as follows: Additional Information: a. On January 11, 2
> Metro Inc. reported net income of $150,000 for 2017. Changes occurred in several balance sheet accounts during 2017 as follows: Investment in Videogold Inc. stock, carried on the equity basis ……………...……………...……………...v $5,500 increase Accumulated deprec
> Alp Inc. had the following activities during 2017: Acquired 2,000 shares of stock in Maybel Inc. for $26,000. Sold an investment in Rate Motors for $35,000 when the carrying value was $33,000. Acquired a $50,000, four-year certificate of deposit from
> Lino Company’s worksheet for the preparation of its 2017 statement of cash flows included the following information: Lino’s 2017 net income is $150,000. Required: What amount should Lino include as net cash that is
> The income statement and statement of cash flows for ABC Equipment Company for 2017 are provided below. Supplemental Information: Other current liabilities represent obligations for general and administrative expenses. Derive a direct method presen
> Bostonian Company provided the following information related to its defined benefit pension plan for 2017: PBO on 1/1 …………………….…………………….………… $2,500,000 Fair value of plan assets on 1/1 ………………………… 2,000,000 Service cost …………………….…………………….………... 120,000 Ac
> On January 1, 2017, Pack Corp. acquired all of Slam Corp.’s common stock for $500,000. On that date, the fair values of Slam’s net assets equaled their book values of $400,000. During 2017, Slam paid cash dividends of
> Fountain Inc. has 5,000,000 shares of common stock outstanding on January 1, 2017. It issued an additional 1,000,000 shares of common stock on April 1, 2017, and 500,000 more on July 1, 2017. On October 1, 2017, Fountain issued 10,000 convertible bonds;
> Effective April 27, 2017, Dorr Corporation’s shareholders approved a two-for-one split of the company’s common stock and an increase in authorized common shares from 100,000 shares (par value of $20 per share) to 200,000 shares (par value of $10 per shar
> The following information pertains to Lee Corporation’s defined benefit pension plan for 2017: Service cost ……………….……………….……………….…………… $160,000 Actual and expected return on plan assets ……………….……………….35,000 Amortization of prior service costs ……………….……
> Hukle Company has provided the following information pertaining to its postretirement plan for 2017: Service cost ……………….…………………………. $240,000 Benefit payment made at 12/31 ……………………. 110,000 Interest on accumulated postretirement benefit obligation…
