On the 2005 income statement, Costiuk reported $300,000 of net income. Rachkovsky reviews the share equity footnote. Relevant excerpts are provided below: • Average number of common shares outstanding throughout the year is 20,000. • Preferred shares with a face value of $100,000 and paying a 1.5 percent cumulative quarterly dividend were outstanding throughout the entire year. • Convertible bonds with a face value of $200,000 and an annual coupon rate of 10 percent were issued on July 1, 2005. They are convertible into common shares at the rate of 15 shares per $1,000 face value. • 7,500 warrants were outstanding with an exercise price of $42. They were issued on January 1, 2005. The average market share price during the year was $40. Upon further analysis, Rachkovsky wonders whether basic or diluted EPS is more suitable for general valuation purposes. The footnotes also reveal that Costiuk has a 100 percent owned subsidiary, Megan Inc. Megan’s capital structure consists solely of redeemable preferred shares, common shares, and zero-coupon bonds. Rachkovsky has calculated Costiuk’s relevant marginal tax rate for the year to be 35 percent. The long-term debt footnote reveals that Costiuk retired some debt on September 1, 2005 that had a maturity date of September 1, 2010. A gain of $125,000 was recognized on the income statement relating to the early retirement. Finally, during the year Costiuk made a voluntary change in its revenue-recognition policy to more accurately reflect reality (slightly later recognition). As a result, a charge of $250,000 was made to the income statement and was separately disclosed as an unusual or nonrecurring item. The revenue recognition change met with the approval of the external auditors. Rachkovsky is considering performing a preliminary valuation of Costiuk and wants to base his valuation only on earnings from continuing operations. Based on Rachkovsky’s stated valuation approach, what is the most appropriate way to treat the gain on early debt retirement and the revenue recognition change, respectively? Gain on Early Debt Retirement Revenue Recognition Change A. Disregard Disregard B. Disregard Consider C. Consider Disregard D. Consider Consider
C?
C
exclude extraordinary items, consider conservative accounting: B
i’d go with B. but man, that is a lot of unnecesary info.
I am just confused on what consider/disregard implies. He should consider adjusting for the early retirement or disregard it as meaning to adjust it?
disregard means he should not include it consider means that he should include it
So reduce earnings for the gain on debt and include the new revenue recog?
The correct answer is C Early extinguishment of debt is no longer automatically considered an extraordinary item. SFAS 145 requires the debt retirement to be included in the continuing operations of a company. Therefore, this item would be considered for valuation purposes. Professor’s note: This is because most companies use debt refinancing as a normal risk management tool. The revenue recognition policy change is an example of a nonrecurring item. It would form part of the “below-theline” earnings that do not originate from continuing operations and would not be used for valuation purposes. This is in contrast to “above-the-line” earnings (such as the early extinguishment of debt) that capture income from continuing operations and would be used for valuation purposes.
wow. got worked.
lol yea…glad I wasn’t the only one. Hope its a lot more straight forward come exam day or I will never see that charter for another extra year…