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(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

Expert verified

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

01

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.

02

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.

03

Journal entries

Date

Accounts and Explanation

Debit $

Credit $

Cash

20,040,000

Discount on bond payable

($18,000,000×22%)

3,960,000

Bonds payable

$18,000,000

Paid-in-capital – Stock warrants

($20,040,000+$3,960,000-18,000,000)

$6,000,000

$24,000,000

$24,000,000

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Most popular questions from this chapter

Ferraro, Inc. established a stock-appreciation rights (SARs) program on January 1, 2017, which entitles executives to receive cash at the date of exercise for the difference between the market price of the stock and the pre-established price of \(20 on 5,000 SARs. The required service period is 2 years. The fair value of the SARs are determined to be \)4 on December 31,2017, and $9 on December 31, 2018. Compute Ferraro’s compensation expense for 2017 and 2018.

EXCEL (Entries for Conversion, Amortization, and Interest of Bonds) Volker Inc. issued \(2,500,000 of convertible 10-year bonds on July 1, 2017. The bonds provide for 12% interest payable semiannually on January 1 and July 1. The discount in connection with the issue was \)54,000, which is being amortized monthly on a straight-line basis. The bonds are convertible after one year into 8 shares of Volker Inc.’s \(100 par value common stock for each \)1,000 of bonds. On August 1, 2018, $250,000 of bonds were turned in for conversion into common stock. Interest has been accrued monthly and paid as due. At the time of conversion, any accrued interest on bonds being converted is paid in cash.

Instructions

Prepare the journal entries to record the conversion, amortization, and interest in connection with the bonds as of the following

dates. (Round to the nearest dollar.)

(a) August 1, 2018. (Assume the book value method is used.)

(b) August 31, 2018.

(c) December 31, 2018, including closing entries for end-of-year.

Earnings per share can affect market prices of common stock. Can market prices affect earnings per share? Explain.

Briefly explain the accounting requirement for stock compensation plans under GAAP.

(Conversion of Bonds) On January 1, 2016, when its \(30 par value common stock was selling for \)80 per share, Plato Corp. issued \(10,000,000 of 8% convertible debentures due in 20 years. The conversion option allowed the holder of each \)1,000 bond to convert the bond into five shares of the corporation’s common stock. The debentures were issued for \(10,800,000.The present value of the bond payments at the time of issuance was \)8,500,000, and the corporation believes the difference between the present value and the amount paid is attributable to the conversion feature. On January 1, 2017, the corporation’s \(30 par value common stock was split 2 for 1, and the conversion rate for the bonds was adjusted accordingly. On January 1, 2018, when the corporation’s \)15 par value common stock was selling for $135 per share, holders of 30% of the convertible debentures exercisedtheir conversion options. The corporation uses the straight-line method for amortizing anybond discounts or premiums.

a) Prepare in general journal form the entry to record the original issuance of the convertible debentures.

(b) Prepare in general journal form the entry to record the exercise of the conversion option, using the book value method.

Show supporting computations in good form.

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