CHAPTER 15 Financial Reporting for Owners’ Equity
c. Black-Scholes method.
d. par value method.
87. Financial statement users must recognize that interest expense may seriously
a. overstate the true cost of debt financing when convertible debt is used.
b. understate the true cost of debt financing when convertible debt is used.
c. impact the dividend rate.
d. impact the amount of dividend declared.
88. Which of the following correctly describes U.S. GAAP accounting for convertible bonds and
the implication of that requirement?
a. separation of debt and equity components; interest expense is overstated.
b. no separation of debt and equity components; interest expense is understated.
c. no separation of debt and equity components; interest expense is overstated.
d. separation of debt and equity components; interest expense is understated.
Use the following to answer questions 89 – 91:
REFERENCE: Ref. 15_07
Cheery Company follows IFRS for its financial reporting. On January 1, 2018 Cheery issued
€250 million of 10–year convertible notes that pay interest at 5% annually. Investors pay €250
million for the notes even though the company’s credit risk at the time implies a 10% interest
rate for traditional debt of similar duration. When the cash flows associated with the debt are
discounted at 10%, the resulting value is €175 million.
89. How much interest expense will be recorded on Cheery’s December 31, 2018 income
statement?
a. €25 million
b. €12.5 million
c. €17.5 million
d. €8.75 million
[QUESTION]
REFER TO: Ref. 15_07
90. How much cash will Cheery pay for interest during 2018?
a. €25 million
b. €12.5 million
c. €17.5 million
d. €8.75 million
91. When Cheery records interest expense on December 31, 2018 the entry will include
a. A debit to interest expense for €25 million.
b. A credit to Convertible notes payable for €12.5 million.
c. A debit to Convertible notes payable for €17.5 million.
d. A credit to Convertible notes payable for €5 million
Problems
92. The Squash Company’s shareholders’ equity on January 1, 2018 was $3,125,500. During
2018, Squash Company reported the following:
• Net income of $575,325.
• Declared cash dividends totaling $125,000; the dividends had not been paid as of
December 31, 2018
• Issued 10,000 shares of $5 par value common stock at $9 per share.
• Purchased 5,000 shares of its common stock for $9.75 per share; the shares are
being held as treasury shares.
• Sold 1,500 shares of treasury stock for $9.25 per share.
Required:
Prepare the balance of shareholders’ equity as of December 31, 2018.
93. The Sports Corporation previously issued convertible bonds with a maturity value of
$5,000,000; the book value of the bonds as of October 1, 2018 was $5,250,000. Each $1,000
bond is convertible into 100 shares of $5 par value common stock. On October 1, 2018, bonds
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with a maturity value of $2,000,000 were converted into common stock; the common stock’s
market value on the conversion date was $12.75 per share.
Required:
Using the above facts only:
1) Prepare the journal entry to record the bond conversion using the book value method.
2) Prepare the journal entry to record the bond conversion using the market value method.
94. Evert Company recently acquired 5,000 shares of its $2 par value common stock for $10 per
share. Evert initially issued the stock for $7.50 per share.
Required:
1. Assuming the shares were purchased as treasury shares, prepare the necessary journal
entry to record the purchase of the 5,000 shares.
2. Continuing with the assumption that the shares were purchased as treasury shares,
prepare the journal entry to record the sale of 2,500 shares of the treasury stock for $11.50
per share.
3. Continuing with the assumption that the shares were purchased as treasury shares,
prepare the journal entry to record the subsequent sale of 2,000 shares of treasury stock for
$9.75 per share.
4. Assuming the shares were purchased and retired, prepare the journal entry to record the
retirement of the shares.
95. Penn Company had 10,000,000 shares of common stock outstanding on January 1, 2018.
Penn entered into the following stock transactions during 2018:
• 2,000,000 shares of common stock were issued on April 1st.
• 600,000 shares of common stock were purchased on May 1st and were being
held as treasury stock.
• 500,000 shares of preferred stock were issued on July 1st.
• 400,000 shares of treasury stock were reissued on October 1st.
• A 2-for-1 common stock split was declared on November 1st.
• Bonds convertible into 1,200,000 shares of common stock were issued on
December 1st; the bonds are considered to be dilutive.
Required:
Determine the number of shares to be used in the calculation of
1) Basic EPS
2) Diluted EPS.
96. The Dunlop Corporation reported basic EPS of $3.50 for the year ended December 31, 2018;
the denominator used in the basic EPS calculation was 360,000 shares. Dunlop’s marginal
income tax rate is 40%. Dunlap had the following convertible securities outstanding during the
entire year:
• 8% convertible preferred stock with a total par value of $1,000,000; the preferred stock is
convertible into 22,000 shares of common stock.
• 10% convertible bonds with a total par value of $6,000,000; the convertible bonds are
convertible into 120,000 shares of common stock.
Required:
Calculate the diluted EPS. (Hint: First test each security separately for dilution.)
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97. The Slazenger Company has provided the following information:
• Shareholders’ equity on January 1, 2018 was $2,225,900.
• Shareholders’ equity on December 31, 2018 was $2,379,300.
• Treasury stock costing $71,000 was sold for $62,000; the treasury stock was
acquired during 2017.
• A property dividend was declared and distributed during 2018. The property’s
book value was $42,325 on the declaration date; the property’s fair value was
$54,485 on the declaration date and $57,500 on the distribution date.
• 10,000 shares of $20 par value preferred stock were purchased and retired during
2018. The shares were initially issued for $25 per share and were purchased for
$29 per share.
• 5,000 shares of $5 par value common stock were issued as the result of a small
stock dividend. The market value per share was $9 at the declaration date and
$9.50 at the distribution date.
• Cash dividends declared and paid during the year totaled $70,000.
Required:
What was Slazenger’s 2018 net income assuming that the only other transactions impacting
shareholders’ equity are described above?
98. Prince Corp. has the following balance sheet information at December 31, 2018.
Current liabilities $ 545,000
Convertible bonds ($1,000 par, 7%) 4,000,000
Common stock ($1 par, 100,000 shares issued) 100,000
Additional paid-in capital 1,000,000
Retained earnings 2,000,000
Treasury stock (9,000 shares) (360,000)
Total liabilities and shareholder’s equity $7,285,000
The convertible bonds were issued at par on April 1, 2018 and are convertible into
Prince’s common stock at a ratio of 25 shares of stock to 1 bond. Prince did not have any
treasury stock at December 31, 2017 and purchased the 9,000 shares evenly throughout
2018. The average price of the common stock for the year was $40, and the year-end
price was $45.
Prince Corp. also has 60,000 outstanding and exercisable qualified employee stock
options. Employees obtain one share of stock for each option exercised. The exercise
price for each option is $21 per share.
Prince’s net income for the year ended 2018 was $292,500. Its tax rate for the year was
35%.
Required:
1. Compute basic EPS for the year ended December 31, 2018. Show all computations.
2. Compute diluted EPS for the year ended December 31, 2018. Show all computations.
Answer:
99. McQueen, Inc. grants 200,000 nonqualified stock options to Robert Chalmers, the CEO, on
January 1, 2018. The par value of McQueen’s common stock is $1. The exercise price on
the options is $35 per share, and the options are exercisable in two years. The stock price on
January 1, 2018 is $31 per share. This is a fixed option plan. Using the Black-Scholes option
pricing model, the value of each option is estimated to be $15.50 at the date of grant. Stock
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prices are $45, $65, and $50 at December 31, 2018, 2019, and 2020, respectively. Robert
exercises his options on April 14, 2021, when the stock price is $57 per share.
Required:
1. Using current GAAP, how much expense will McQueen, Inc. recognize for the year
ended December 31, 2019 related to the options?
2. Prepare the journal entries needed on the date of exercise.
100. On January 2, 2018, Cannon Company issued $10,000,000 of convertible debt. The bonds
are zero-coupon, and each $1,000 bond is convertible into 10 shares of Cannon Company’s
common stock at the bond holder’s option. The bonds mature in 2022 and were issued at par.
Companies with similar credit profiles were issuing non-convertible debt at an effective rate of
interest of 8%. The present value factor for $1 for 5 periods at 8% is .68058. For each of the
following assumptions, prepare the journal entry to record the issuance of debt and entries for
2018 and 2019 to record interest expense. No bonds were converted during 2018 or 2019.
A. Cannon Company uses U.S. GAAP to prepare its external financial reporting to
shareholders and regulators.
B. Cannon Company uses IFRS to prepare its external financial reporting to shareholders
and regulators.
