Question

(Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.

Instructions

(a) (1) Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.

(2) Discuss the underlying rationale for the differences described in (a)(1) above.

(3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants.

(b) At the start of the year, Huish Company issued \(18,000,000 of 12% bonds along with detachable warrants to buy 1,200,000 shares of its \)10 par value common stock at \(18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of \)1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have sold in the market at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received.

Short answer

1.(1) If the debt instruments and the options cannot be separated, then the received amount is allocated to bonds and discount on bonds. At the same time, if they are separable, they are assigned to their respective account on their fair value.

(2) Amount from the issue of convertible debt is allocated to debt because they are inseparable and due to valuation problems.

(3) The situation becomes difficult when the amount of debt and option cannot be identified separately.

2. Cash account is debited by $20,040,000 given in the question and discount on bonds payable account is debited by $3,960,000 which is calculated as 22% of the par value of the bonds payable. Bond payable is credited by $18,000,000 given in the question and stock warrant is credited by the balancing figure of the journal entry.

Step-by-step solution

Definition of Debt Securities

The financial assets that provide a regular income to their owner in the form of interest are known as debt securities. Such securities do not provide any voting and ownership rights.

Difference in the accounting of securities issues for generating capital

(1) If the debt instrument issued cannot be separated from the option, the entire amount received from the issue of bonds is allocated to bonds and discount/premium accounts.

If the debt instrument and options are separable, the amount received from the issue must allocate to their respective accounts based on their fair value. Fair value is decided based on the value of such options in the open market. If the debt instrument and options are separable, the amount received from the issue must allocate to their respective accounts based on their fair value. Fair value is decided based on the value of such options in the open market.

(2) In case of an issue of convertible debt, the amount of proceeding must be allocated to debt because of the following two reasons:

• Option and debt cannot be separated.
• There is a problem in the valuation of the option and the debt security.

(3) Convertible bonds possess the characteristics of both debt and equity. Therefore, both these characteristics are recognized separately at the time of issuance. The difficulty arises when the value of the debt and equity is not calculated separately. For such cases, the business entity can use the allocation method to allocate the amounts separately to debt and equity. The business entity must allocate the amount separately at the time of issuance without considering the probability of exercising the option.

Journal entries

Date	Accounts and Explanation	Debit $	Credit $
	Cash	20,040,000
	Discount on bond payable $\left(\$18,000,000\times 22\%\right)$	3,960,000
	Bonds payable		$18,000,000
	Paid-in-capital – Stock warrants $\left(\$20,040,000+\$3,960,000-18,000,000\right)$		$6,000,000
		$24,000,000	$24,000,000