P15-5. Analyzing convertible debt (LO 15-9)
(AICPA adapted)
Requirement 1:
Journal entry to record the original issuance of the $10 million convertible bond
at par:
Notice that this entry does not assign any value to the conversion option.
Requirement 2:
Interest expense on the bond would be computed and recorded in the usual
4%, so interest expense would be $400,000 (or $10 million x 4%).
Requirement 3:
When issued, each $1,000 bond certificate could be converted into 5 shares of
shares x 40%). The journal entry to
DR Convertible bond payable $4,000,000
Some students may instead use the market value-method described in
Requirement 4.
Requirement 4:
The preceding entry used the “book value” method to record the conversion—
the issued stock was recorded at the book value of the debt retired. Had the
CR Additional paid-in capital 4,800,000
Notice that this entry records the stock at its market value ($90 per share) at
accounting loss when the book-value method is used.
P15-6. Cash-settled convertible debt (LO 15-9)
Part [A]: Using the bifurcation approach as required by U.S.
GAAP:
Requirement 1:
The fair value of the debt and equity components of the convertible
debt instrument would be determined by first measuring the fair
rounded to the nearest dollar.
Requirement 2:
The journal entry to record the issuance of the convertible notes
using the bifurcation approach is:
Requirement 3:
Interest expense in the first year (2018) would be computed as the
DR Interest Expense $423
manner using this new carrying value: $437 rounded = ($7,056 +
$223) X .06.
Requirement 4:
In 2019, Avnext would record interest expense with the following
journal entry:
end of Year 2—would then be $7,516 = $7,056 + $223 + $237.
Requirement 5: The cash settlement amount as of January 1,
2023 is $12,000 and represents the cash value of 400 shares
value of $8,701 and the conversion feature has a settlement date
fair value of $3,299 or $12,000 minus $8,701.
Requirement 6:
The journal entry to record the cash settlement of the notes on
January 1, 2023 is:
*The loss on debt settlement is computed as the difference between
the debt fair value on the settlement date ($8,701) and its carrying
issuance carrying value ($2,944).
Part [B]: Using the traditional approach for convertible debt
that does not have a cash settlement option:
Requirement 1:
Bifurcation would be ignored and the entire proceeds at issuance
would be assigned to the convertible note liability as:
DR Cash $10,000
Requirement 2:
Interest expense in 2018 would be computed as the debt carrying
value ($10,000) multiplied by the implied effective interest rate (2%).
Interest expense for 2019 would also be $200, or the $10,000
carrying value multiplied by the 2% interest rate.
Requirement 3:
The carrying value of the convertible note as of December 31, 2019
Requirement 4:
Absent bifurcation, the following entry would be made to record the
conversion and cash settlement of the note on January 1, 2023:
CR Cash $12,000
P15-7. Computing EPS (LO 15-6)
Requirement 1: Calculation of basic earnings per share
Basic earnings per share =
Net income- Preferred dividends
Weighted-average number of
common shares
=
$1,700,000 – $200,000
230,000*
= $6.52
*Calculation of weighted-average number of common shares:
Shares % of the Year Weighted
Time Period Outstanding Outstanding Average
Total 230,000
Requirement 2: Calculation of diluted earnings per share
Net income – Preferred dividends + Income effect of dilutive securities
Weighted average number of common shares + Shares for dilutive
securities
=
***50,000 +**230,000
*$32,500+$200,000-$1,700,000
= $1,532,500
280,000
= $5.47
*(500,000 x 0.10) x (1.0 – 0.34) = 32,500
**From Requirement 1 above.
***(500,000/1,000) x 100 = 50,000
Requirement 3: Types of dilutive securities
Common examples are options, warrants, convertible debt, and
convertible preferred stock.
Requirement 4: Effects of options
The options would increase the denominator in requirement 2 as
follows:
Shares under option 50,000
The prior diluted EPS is adjusted as follows:
P15-8. Setting limits on dividends (LO 15-4)
Requirement 1:
Lenders restrict a subsidiary’s ability to pay dividends to the parent
corporation so that the subsidiary’s cash flows are available to
earnings (as is the case for General Chemical).
Requirement 2:
The parent company’s dividend payout ratio was just over 7.05%
Requirement 3:
At the end of the year, Tredegar Industries still had about $51,000
Requirement 4:
The year-end balance in retained earnings is $99,027 so the
Business Corporation Act does not apply.
Requirement 5:
Neither restriction seems important because the company declared
dividend.
P15-9. Repurchasing stock and calculating EPS (LO 15-1, LO 15-2)
Requirement 1:
If the stock buyback had not occurred, an additional 1,237,000
would have been:
Year Ended October 31
$ in thousands 2014 2015 2016 2017
Earnings per share as reported $0.50 $0.80 $2.50 $1.13
Earnings per share without share repurchase $0.50 $0.80 $1.92 $0.82
Requirement 2:
After adjusting for the stock repurchase, it becomes clear that
Requirement 3:
Other reasons for the decline in average common shares include
these same securities.
P15-10. Preferred stock and credit analysis (LO 15-3)
Requirement 1:
Entry to record the issuance of preferred stock on January 1, Year
2:
Year 1:
DR Dividends $240.00
CR Cash
CR Cash
$611.52
($611.52 = $7,644 x 8%)
Requirement 3:
The company would make entries identical to those in
deduction for interest.
Requirement 4:
The following schedule shows the computation of AT&T Wireless
Services’ interest coverage and long-term debt to equity ratios for
both years:
As reported 8% Debt
Year 2
Year 1
Year 2
Year 1
Interest expense on debt
$386
$85
$386
$85
$386
$85
$998
Lenders might restrict a company’s ability to issue additional
debt repayment, and this might increase the company’s credit risk.
Requirement 6:
In this case, the (mandatorily redeemable) preferred stock would
P15-11. Calculating earnings per share (LO 15-6)
Requirement 1:
The preferred stock pays a 10% dividend ($500,000), so there
must be $5 million of preferred stock outstanding. Since each
each $100 par value preferred share must convert into 4 shares of
common.
Basic Diluted
Numerator (adjusted earnings)
Net income $6,300,000 $6,300,000
Preferred stock dividend -225,000 -225,000
Interest on convertible note (Note 3) 20,000
Adjusted earnings
$6,075,000
$6,095,000
Denominator (weighted-average shares):
Common outstanding on January 1 1,800,000 1,800,000
Contingently issuable shares
Weighted-average shares
1,893,500
1,906,833
Earnings per share
$3.21
$3.20
1. Common shares issued February 28: 60,000 shares X 10/12
(1- .40 tax rate) X 4/12 of year = $20,000 interest after-tax.
4. Common shares issued upon conversion: 40 shares X 1,000
certificates x 4/12 of year.
Contingently issuable shares (not mentioned in the chapter) are
issuable shares is 60,000 X 0/12 = 0 shares.
Contingently issuable shares are not included in the computation of
basic EPS until issued.