Question

Answer questions 1 and 2 at the bottom

CP 13-6 Issuing stock Epstein Engineering Inc. began operations on January 5, 20Y8, with the issuance of 500,000 shares of $80 par common stock. The sole stockholders of Epstein Engineering Inc. are Barb Abrams and Dr. Amber Epstein, who organized Epstein Engineering Inc. with the objective of developing a new flu vaccine. Dr. Epstein claims that the flu vaccine, which is nearing the final development stage, will protect individuals against 90% of the flu types that have been medically identified. To complete the project, Epstein Engineering Inc. needs $25,000,000 of additional funds. The local banks have been unwilling to loan the funds because of the lack of sufficient collateral and the riskiness of the business. The following is a conversation between Barb Abrams, the chief executive officer of Epstein Engineering Inc., and Amber Epstein, the leading researcher: Barb: What are we going to do? The banks won't loan us any more money, and we've got to have $25 million to complete the project. We are so close! It would be a disaster to quit now. The only thing 1 can think of is to issue additional stock. Do you have any suggestions? Amber:I guess you're right. But if the banks won't loan us any more money, how can we find any Bart : rve been thinking about that what if we promise the investors that we will pay them 5% of sales until they receive an amount equal to what they paid for the stock? Amber: What happens when we pay back the $25 million? Do the investors get to keep the stock? dilute our ownership. Barb: How about if after we pay back the $25 million, we make them turn in their stock for $120 per share? That's one and one-half times what they paid for it, and they would have already gotten all their money back.That's a $120 profit per share for the investors. Amber: It could work. We get our money but don't have to pay any interest, divi until we start generating sales. At the same time, the investors could get their money share proft. back plus $120 per Barb: We'll need current financial statements for the new investors. Ill get our accountant working on contact our attorney to draw up a legally binding contract for the new investors. Yes this could work them and In late 20Y8, the attorney and the various regulatory authorities approved the nevw stock offering, and 312,500 shares of common stock were privately sold to new investors at the stock's par of $80. In preparing financial statements for 20Y8, Barb Abrams and Dan Fisher, the control ler for Epstein Engineering Inc., have the following conversation: Dan: Barb, I've got a problem. Barb: What's that, Dan? Dan: Issuing common stock to raise that additional $25 million was a great idea. But Barb: But what? Dan: I've got to prepare the 20Y8 annual financial statements, and I am not sure how to classify the common stock Barb: What do you mean? It's common stock. Dan:I'm not so sure. I called the auditor and explained how we are contractually obligated to pay the new stock holders 5% of sales until S80 per share is paid. Then we may be obligated to pay them S120 per share. Barb: So Dan: So the auditor thinks that we should classify the additional issuance of $25 million as debt, not stock! And if we put the $25 million on the balance sheet as debt, we will violate our other loan agreements with the banks. And if these agreements are violated, the banks may call in all our debt immediately. If they do that, we are in deep trouble. We'll probably have to file for bankruptcy. We just don't have the cash to pay off the banks Discuss the arguments for and against classifying the issuance of the What might be a practical solution to this classification problem? 1. $25 million of stock as debt. 2.

Answer 1

The current funding from the new investors is in the form of convertible shares. In the current scenario, the company intends to first repay $80 through a consistent payment of 5% of sales, which is in the nature of debt. Post the same, it will buyback the shares @ 120 after the amount has been completely paid.

As the first leg of the transaction is in the nature debt, the same will be accounted under financial liability. At the same time, there is equity portion also present that will be bought back after the debt repayment.

At the same time, one can argues that against the $80 the company is issuing shares hence, it must be classified as Shareholders funds.

Companies often finance operations with securities that have characteristics of both debt and equity. These securities, such as convertible debt or puttable preferred stock, are often referred to as equity-linked instruments. Equity-linked instruments can be an attractive form of financing for both investors and issuers. Investors often obtain a minimum guaranteed return, or a more senior security, and also benefit if the issuer’s stock appreciates. Issuer’s on the other hand obtain needed financing, and benefit from a lower cash coupon or dividend.

From a balance sheet perspective, equity-linked instruments can be classified as debt, equity, or mezzanine equity.

Companies can also be required to separate embedded derivatives and classify each component appropriately. Additionally, while some instruments, are carried at amortized cost, others, are measured at fair value. Changes in instruments measured at fair value need to be reflected in either earnings or other comprehensive income, depending on the instrument.

Let’s start with certain equity-linked instruments classified as liabilities. In practice we see mandatorily redeemable shares often meeting this guidance, as the issuer has an unavoidable obligation to redeem them for cash. If an instrument is not a liability carried at fair value, an issuer would evaluate whether any features embedded in the instrument must be separately accounted for as a derivative. Common features that need to be considered include put and call options, conversion options, and certain features that modify the interest rate. Generally speaking, separation is required when a derivative feature introduces economics that are considered different from the host contract, for example, an equity return embedded in a debt instrument. In such situations we would say the embedded feature is not clearly and closely related to the host contract..

If separation of a derivative is required, also known as bifurcation, then a portion of the total proceeds would be allocated to the embedded derivative, and it would be marked to market through earnings. The host instrument would continue to be accounted for in accordance with other literature. It’s worth noting that if the host is a debt instrument, then for accounting purposes that debt would be considered issued at a discount, which would generate additional interest expense.

Once a company determines that the instrument, such as preferred stock, is not a liability, it must assess whether it should be classified as permanent equity or mezzanine equity. Mezzanine classification would be appropriate when a company issues an equity security that it might have to settle for cash at the option of the holder, but cash settlement is not certain. Examples include common shares that are contingently puttable upon a change of control, a violation of covenants, or in the event the Company fails to sell a division by a certain date.

As you can see from these highlights, analyzing and accounting for equity-linked instruments can be complex,