Chapter 16: Question 19 (page 874)
What are the computational guidelines for determining whether a convertible security is to be reported as part of diluted earnings per share?
The EPS before the change is higher than the EPS with conversion.
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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?
Rockland Corporation earned net income of \(300,000 in 2017 and had 100,000 shares of common stock outstanding throughout the year. Also outstanding all year was \)800,000 of 9% bonds, which are convertible into 16,000 shares of common. Rockland’s tax rate is 40%. Compute Rockland’s 2017 diluted earnings per share.
CA16-6 WRITING (EPS, Antidilution) Brad Dolan, a stockholder of Rhode Corporation, has asked you, the firm’s accountant, to explain why his stock warrants were not included in diluted EPS. In order to explain this situation, you must briefly explain what dilutive securities are, why they are included in the EPS calculation, and why some securities are antidilutive and thus not included in this calculation.
Rhode Corporation earned \(228,000 during the period, when it had an average of 100,000 shares of common stock outstanding. The common stock sold at an average market price of \)25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant.
Instructions
Write Mr. Dolan a 1–1.5-page letter explaining why the warrants are not included in the calculation.
Explain how convertible securities are determined to be potentially dilutive common shares and how those convertible securities that are not considered to be potentially dilutive common shares enter into the determination of earnings per share data.
Four years after issue, debentures with a face value of \(1,000,000 and book value of \)960,000 are tendered for conversion into 80,000 shares of common stock immediately after an interest payment date. At that time, the market price of the debentures is 104, and the common stock is selling at \(14 per share (par value \)10). The company records the conversion as follows. Bonds Payable 1,000,000 Discount on Bonds Payable 40,000 Common Stock 800,000 Paid-in Capital in Excess of Par— Common Stock 160,000 Discuss the propriety of this accounting treatment.
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