Question

Accounting, Analysis, and Principles

On January 1, 2016, Garner issued 10-year, \(200,000 face value, 6% bonds at par. Each \)1,000 bond is convertible into 30 shares of Garner \(2 par value common stock. The company has had 10,000 shares of common stock (and no preferred stock) outstanding throughout its life. None of the bonds have been converted as of the end of 2017. (Ignore all tax effects.)

Accounting

(a) Prepare the journal entry Garner would have made on January 1, 2016, to record the issuance of the bonds.

(b) Garner’s net income in 2017 was \)30,000 and was \(27,000 in 2016. Compute basic and diluted earnings per share for Garner for 2017 and 2016.

(c) Assume that 75% of the holders of Garner’s convertible bonds convert their bonds to stock on June 30, 2018, when Garner’s stock is trading at \)32 per share. Garner pays $50 per bond to induce bondholders to convert. Prepare the journal entry to record the conversion.

Analysis

Show how Garner will report income and EPS for 2017 and 2016. Briefly discuss the importance of GAAP for EPS to analysts evaluating companies based on price-earnings ratios. Consider comparisons for a company over time, as well as comparisons between companies at a point in time.

Principles

In order to converge GAAP and IFRS, the FASB is considering whether the equity element of a convertible bond should be reported as equity. Describe how the journal entry you made in part (a) above would differ under IFRS. In terms of the accounting principles discussed in Chapter 2, what does IFRS for convertible debt accomplish that GAAP potentially sacrifices? What does GAAP for convertible debt accomplish that IFRS potentially sacrifices?

Short answer

(a) Cash account is debited, and bond payable is credited by $200,000

(b) Basic and diluted EPS for the years 2016 and 2017 are:

Particular	2016	2017
Basic EPS	$2.7	$3
Diluted EPS	$2.43	$2.62

(c) The bond conversion expense is $7,500

Step-by-step solution

Definition of Convertible Bonds

The bonds issued by the business entity convertible into a stated number of company’s shares after specified periods are known as convertible bonds.

Journal entry for issuance of bonds

Date	Accounts and Explanation	Debit ($)	Credit ($)
1 Jan 2016	Cash	200,000
	Bonds payable		200,000
		$200,000	$200,000

Earnings per share

Basic earnings per share
Year	Net income	/	Common shares outstanding	=	Earnings per share
2016	$27,000	/	10,000	=	$2.7
2017	$30,000	/	10,000	=	$3.00

Diluted earnings per share
	2016	2017
Net income	$27,000	$30,000
Add: interest saving$(\$200,000\times 6\%)$	12,000	12,000
Adjusted net income	39,000	42,000
Outstanding shares	10,000	10,000
Add: converted bonds into shares$(\frac{\$200,000}{\$1,000}\times 30)$	6,000	6,000
Total outstanding shares	16,000	16,000
Diluted EPS	$2.43	$2.62

Journal entry to record conversion

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Bond conversion expenses (working note 1)	7,500
	Bond payable	150,000
	Common stock(working note 2)		9,000
	Paid-in-capital in excess of par (balancing figure)		141,000
	Cash$(150\times \$50)$		7,500
		$157,500	$157,500

Working note:

1. Calculation of bond conversion expenses$\begin{array}{c}\text{Bond\hspace{0.17em}conversion\hspace{0.17em}expenses}=(\frac{\$200,000}{\$1,000}\times 75\%\times \$50)\\ =\$7,500\end{array}$

   2.Calculation of amount credited in common stock

   $\begin{array}{c}\text{Common\hspace{0.17em}stock}=(\frac{\$200,000}{\$1,000}\times 30\times 75\%\times \$2)\\ =\$9,000\end{array}$

Analysis

Representation of EPS

Particular	2016	2017
Net income	$27,000	$30,000
Basic EPS	$2.7	$3
Diluted EPS	$2.43	$2.62

EPS is important for the analyst who depends upon the earnings per share to determine the business entity’s performance. EPS is also used to calculate the price-earnings ratio, which helps determine the quality of the earnings and growth prospects of the company. If the company uses more variations in the EPS calculation, it becomes more difficult to compare the companies and the company over time.

Principles

Under IFRS, the company must separate the equity and debt component of the convertible bonds from recording the issuance. Suppose the business entity calculated that the equity portion of a convertible bond equals $80,000. Then, the journal entry made will be:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Cash	200,000
	Discount on bonds payable	80,000
	Bonds payable		200,000
	Share premium – conversion equity		80,000

Analyst supporting treatment made under IFRS will state that separating debt and equity components will provide a clear and fair view.

While analysts supporting treatment made under GAAP will state that allocating amount to debt and equity components is difficult and does not provide real figures.