Chapter 14, Problem 9P

1.

To determine

Prepare the journal entries to record bond conversion using (a) book value method and (b) market value method.

Explanation of Solution

Induced Conversion: Induced conversion is a method wherein, the convertible bonds issued by the company are converted into common stock in order to reduce interest costs or for increasing the debt-to-equity ratio of the company.

(a).

Prepare journal entry to record conversion of bonds using book value of method.

Date	Account titles and Explanation	Debit	Credit
March 1, 2018	Bonds payable	$300,000
	Premium on bonds payable (2)	$19,200
	Common stock (1)		$75,000
	Additional paid in capital from bond conversion (balancing figure)		$244,200
	(To record conversion of bonds)
March 1, 2020	Bonds payable	$1,200,000
	Premium on bonds payable (5)	$52,800
	Common stock (4)		$300,000
	Additional paid in capital from bond conversion		$952,800
	(To record conversion of bonds)

Table (1)

As on 1^st March 2018:

• Bonds payable is a liability, and it is decreased. Therefore, debit bonds payable account for $300,000.
• Premium on bonds payable is an adjunct liability, and it is increased. Therefore, debit discount on bonds payable account for $19,200.
• Common stock is a component of stockholders’ equity, and it is increased. Therefore, credit common stock account for $75,000.
• Additional paid in capital on common stock is a component of stockholders’ equity, and it is increased. Therefore, credit additional paid in capital on common stock account for $244,200.

As on 1^st March 2020:

• Bonds payable is a liability, and it is decreased. Therefore, debit bonds payable account for $1,200,000.
• Premium on bonds payable is an adjunct liability, and it is increased. Therefore, debit discount on bonds payable account for $52,800.
• Common stock is a component of stockholders’ equity, and it is increased. Therefore, credit common stock account for $300,000.
• Additional paid in capital on common stock is a component of stockholders’ equity, and it is increased. Therefore, credit additional paid in capital on common stock account for $952,800.

Working notes:

(1)Calculate common stock.

$\begin{array}{c}\text{Common stock =}\left(\begin{array}{l}\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \text{Convertible }\\ \text{common shares}\times \text{Face value}\text{per share}\end{array}\right)\\ \text{=}\left(\frac{\$300,000}{\$1,000}\right)\times 25\text{Common shares}\times \text{\$10}\\ \text{=}300\times 25\times \$10\\ =\$75,000\end{array}$

(2)Calculate premium on bonds payable.

$\begin{array}{c}\text{Premium on bonds =}\text{Unamortized premium}\times \frac{\text{Converted convertible bonds}}{\text{Total convertible bonds}}\\ =\$96,000\times \frac{\$300,000}{\$1,500,000}\\ =\$19,200\end{array}$

(3)Calculate unamortized premium on bonds.

$\begin{array}{c}\text{Unamortized premium}\text{=}\text{Total amount to be amortized }-\text{Amortized bonds}\\ \text{=}\left(\$1,620,000-\$1,500,000\right)-\left(\left(\frac{\$120,000}{120\text{months}}\right)\times 24\text{months}\right)\\ =\$120,000-\$24,000\\ =\$96,000\end{array}$

(4)Calculate common stock.

$\begin{array}{c}\text{Common stock =}\left(\begin{array}{l}\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \text{Convertible }\\ \text{common shares}\times \text{Face value}\text{per share}\end{array}\right)\\ \text{=}\left(\frac{\$1,200,000}{\$1,000}\right)\times 25\text{Common shares}\times \text{\$10}\\ \text{=}1,200\times 25\times \$10\\ =\$300,000\end{array}$

(5)Calculate premium on bonds payable.

$\begin{array}{c}\text{Premium}\text{on bonds}\text{=}\frac{\text{Unamortized premium on bonds}}{\text{Total number of months}}\times \text{lapsed months}\\ \text{=}\left(\left(\frac{\$96,000}{120\text{months}}\right)\times \left(120-24\text{months}\right)\right)\\ =\$800\text{per month}\times \text{66}\text{months}\\ =\$52,800\end{array}$

(b)

Prepare journal entry to record conversion of bonds using market value of method.

Date	Account titles and Explanation	Debit	Credit
March 1, 2018	Bonds payable	$300,000
	Premium on bonds payable (2)	$19,200
	Common stock (1)		$75,000
	Additional paid in capital from bond conversion (6)		$135,000
	Gain from bond conversion		$109,200
	(To record conversion of bonds)
March 1, 2020	Bonds payable	$1,200,000
	Premium on bonds payable (5)	$52,800
	Common stock (4)		$300,000
	Additional paid in capital from bond conversion (7)		$600,000
	Gain from bond conversion		$352,800
	(To record conversion of bonds)

Table (2)

As on 1^st March 2018:

• Bonds payable is a liability, and it is decreased. Therefore, debit bonds payable account for $300,000.
• Premium on bonds payable is an adjunct liability, and it is increased. Therefore, debit discount on bonds payable account for $19,200.
• Common stock is a component of stockholders’ equity, and it is increased. Therefore, credit common stock account for $75,000.
• Additional paid in capital on common stock is a component of stockholders’ equity, and it is increased. Therefore, credit additional paid in capital on common stock account for $135,000.
• Gain on redemption of bonds is a component of stockholders’ equity, and it is increased. Therefore, credit gain on redemption of bonds account for $109,200.

As on 1^st March 2020:

• Bonds payable is a liability, and it is decreased. Therefore, debit bonds payable account for $1,200,000.
• Premium on bonds payable is an adjunct liability, and it is increased. Therefore, debit discount on bonds payable account for $52,800.
• Common stock is a component of stockholders’ equity, and it is increased. Therefore, credit common stock account for $300,000.
• Additional paid in capital on common stock is a component of stockholders’ equity, and it is increased. Therefore, credit additional paid in capital on common stock account for $600,000.
• Gain on redemption of bonds is a component of stockholders’ equity, and it is increased. Therefore, credit gain on redemption of bonds account for $352,800.

Working notes:

(6)Calculate additional paid in capital from bond conversion.

$\begin{array}{c}\begin{array}{l}\text{Additional paid in capital}\\ \text{ -}\text{common stock}\end{array})\text{ =}\left(\begin{array}{l}\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \text{Convertible }\\ \text{common shares}\times \left(\begin{array}{l}\text{Market value per share }\\ -\text{Face value}\text{per share}\end{array}\right)\end{array}\right)\\ \text{=}\left(\frac{\$300,000}{\$1,000}\right)\times 20\text{Common shares}\times \left(\$28-\$10\right)\\ \text{=}300\times 25\times \$18\\ =\$135,000\end{array}$

(7)Calculate additional paid in capital from bond conversion.

$\begin{array}{c}\begin{array}{l}\text{Additional paid in capital}\\ \text{ -}\text{common stock}\end{array})\text{ =}\left(\begin{array}{l}\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \text{Convertible }\\ \text{common shares}\times \left(\begin{array}{l}\text{Market value per share }\\ -\text{Face value}\text{per share}\end{array}\right)\end{array}\right)\\ \text{=}\left(\frac{\$1,200,000}{\$1,000}\right)\times 25\text{Common shares}\times \left(\$30-\$10\right)\\ \text{=}1,200\times 25\times \$20\\ =\$600,000\end{array}$

2.

To determine

Explain whether the company assign a value to a conversion feature under GAAP method, how the evaluation would be determined.

Explanation of Solution

The conversion feature would possibly have to be valued by valuing the difference in the yield rates between the convertible bond and an equivalent bond that would have been issued by the company but without a conversion feature. The present value of the future cash flows discounted using this differential rate would be to calculate the average differential yield rate that happens for all companies in the market, and use this value to calculate the present value of the conversion feature.

3.

To determine

Compute the Company debt to equity ratio under each alternative, assume the company other liabilities are $3,000,000, and the shareholders’ equity before conversion is $3,500,000. Calculate the ratio before and after 1^st March 2018.

Explanation of Solution

Compute debt to equity ratio before the conversion.

$\begin{array}{c}\text{Debt to equity ratio =}\frac{\text{Total liabilites}}{\text{Total stockholders'}\text{equity}}\\ =\frac{\$3,000,000+\$1,596,000}{\$3,500,000}\\ =1.31\end{array}$

Compute debt to equity ratio after conversion accounted for with book value method.

$\begin{array}{c}\text{Debt to equity ratio =}\frac{\text{Total liabilites}}{\text{Total stockholders'}\text{equity}}\\ =\frac{\$3,000,000+\$1,596,000-\$319,200}{\$3,500,000+\$319,200}\\ =\frac{\$4,276,800}{\$3,819,200}\\ =1.12\end{array}$

Compute debt to equity ratio after conversion computed for with market value method.

$\begin{array}{c}\text{Debt to equity ratio =}\frac{\text{Total liabilites}}{\text{Total stockholders'}\text{equity}}\\ =\frac{\$3,000,000+\$1,596,000-\$319,200}{\$3,500,000+\$319,200}\\ =\frac{\$4,276,800}{\$3,819,200}\\ =1.12\end{array}$

4.

To determine

Prepare journal entry to record issuance of bonds, assume the company uses IFRS and issued for $1,620,000 on 1^st March 2019, and the fair value of each bond was $1,040 and the fair value of conversion option was $40 per bond.

Explanation of Solution

Prepare journal entry to record issuance of bonds.

Date	Account Titles and Explanation	Debit	Credit
March 1, 2016	Cash	$1,620,000
	Bonds payable (8)		$1,560,000
	Additional paid in capital – conversion option (4)		$60,000
	(To record issuance of bonds payable)

Table (3)

• Cash is a current asset, and it is increased. Therefore, debit cash account for $1,620,000.
• Bonds payable is a liability, and it is increased. Therefore, credit bonds payable account for $1,560,000.
• Additional paid in capital – conversion option is a component of stockholders’ equity, and it is increased. Therefore, credit Additional paid in capital – conversion option account for $60,000.

Working note:

(8)Calculate bonds payable.

$\begin{array}{c}\text{Bonds payable =}\text{Number of convertible bonds}\times \text{Fair value of bonds}\\ \text{=}\frac{\$1,500,000}{\$1,000}\times \text{\$1,040}\\ \text{=}\$1,560,000\end{array}$