Question

Faith Evans Corporation is a regional company which is an SEC registrant. The corporation’s securities are thinly traded on NASDAQ. Faith Evans Corp. has issued 10,000 units. Each unit consists of a \(500 par, 12% subordinated debenture and 10 shares of \)5 par common stock. The units were sold to outside investors for cash at \(880 per unit. Prior to this sale, the 2-week ask price of common stock was \)40 per share. Twelve percent is a reasonable market yield for the debentures, and therefore the par value of the bonds is equal to the fair value.

Instructions

1. Prepare the journal entry to record Evans’ transaction, under the following conditions.
2. Employing the incremental method.
3. Employing the proportional method, assuming the recent price quote on the common stock reflects fair value.
4. Briefly explain which method is, in your opinion, the better method.

Short answer

In incremental method, total paid-in capital=$3,648,000

In the Proportional method, total paid-in capital in excess of par=$3,254,667

Step-by-step solution

Preparing Journal Entries (Incremental Method)

S.no.	Particular	Folio	Debit $	Credit $
(a)1	Unamortized Bond Issue Costs A/c.		200,000
	Cash		8,448,000
	Paid-in Capital in excess of par common Stock A/c.			5,000,000
	Common Stock			500,000
	Paid-in Capital in excess of par- Common Stock			3,148,000
	Common Stock
	To record for the issue of bond

$\begin{array}{rcl}\mathrm{Unamortized}\mathrm{bond}\mathrm{issue}\mathrm{cost}& =& \mathrm{Total}\mathrm{issue}\mathrm{cost}\times \frac{\mathrm{Per}\mathrm{unit}\mathrm{cost}}{\mathrm{Per}\mathrm{unit}\mathrm{cost}\mathrm{to}\mathrm{outsider}}\\ & =& \$352,000\times \frac{\$500}{\$880}\\ & =& \$200,000\end{array}$

Assuming bonds are properly priced and issued at par, residual attributed to common stock has a questionable measure of fair value.

Performing Incremental Method

Lump-sum receipt	$8,448,000
Less-Allocated to subordinated debenture	4,800,000
Balance allocated to common stock	$3,648,000

$\begin{array}{rcl}\mathrm{Share}\mathrm{allocation}\mathrm{to}\mathrm{common}\mathrm{stock}& =& \mathrm{Lump}-\mathrm{sum}\mathrm{receipt}-\mathrm{Allocation}\mathrm{to}\mathrm{subordinate}\mathrm{debenture}\\ & =& \left(9,600\times \$880\right)-\left(9,600\times \$500\right)\\ & =& \$8,448,000-\$4,800,000\\ & =& \$3,648,000\end{array}$

Computation of Common Stock and Paid-in Capital

Balance allocated to common stock	$3,648,000
Less-Common Stock	500,000
Paid-in capital in excess of par	$3,148,000
Lump-sum receipt	$8,800,000
Less-Allocated to subordinated debenture	5,00,000
Balance allocated to common stock	$3,800,000

Bond issue Costs Allocation

Total issue costs (400*$880)	$352,000
Less- Amount allocated to bonds	200,000
The amount allocated to common	$152,000

$\begin{array}{rcl}\mathrm{Allocation}\mathrm{to}\mathrm{debentures}& =& \frac{5}{8.8}\times \mathrm{Investment}\mathrm{banking}\mathrm{cost}\\ & =& \frac{5}{8.8}\times (400\times \$880)\\ & =& \frac{5}{8.8}\times \$352,000\\ & =& \$200,000\end{array}$

$\begin{array}{rcl}\mathrm{Allocation}\mathrm{to}\mathrm{common}\mathrm{stock}& =& \frac{3.8}{8.8}\times \mathrm{Investment}\mathrm{banking}\mathrm{cost}\\ & =& \frac{3.8}{8.8}\times \left(400\times \$880\right)\\ & =& \frac{3.8}{8.8}\times \$352,000\\ & =& \$152,000\end{array}$

$\begin{array}{rcl}\mathrm{Total}\mathrm{paid}-\mathrm{in}\mathrm{capital}& =& \$3,800,000-\$152,000\\ & =& \$3,648,000\end{array}$

Preparing Journal Entries (Proportional Method)

S.no.	Particular	Folio	Debit $	Credit $
(b)2	Cash A/c.		8,448,000
	Unamortized Bond Issue Costs		195,556
	Bond Discount		111,111
	Bond Payable			5,000,000
	Common Stock			500,000
	Paid-in Capital in Excess of Par-common stock			3,254,667
	To record for the issue of bond

Performing Proportional Method

The allocation based on fair value for one unit is

Subordinated debenture	$500
Add-Common Stock	400
Total fair value	$900

Therefore 5/9 is allocated bonds and 4/9 to the common stock.

$\begin{array}{rcl}\mathrm{To}\mathrm{debentures}& =& \$8,800,000\times \frac{5}{9}\\ & =& 4,888,889\\ & & \mathrm{and}\$352,000\times \frac{5}{9}\\ & =& \$195,556\end{array}$

$\begin{array}{rcl}\mathrm{To}\mathrm{common}\mathrm{stock}& =& \$8,800,000\times \frac{4}{9}\\ & =& \$3,911,111\\ & & \mathrm{and}\$352,000\times \frac{4}{9}\\ & =& \$156,444\end{array}$

$\begin{array}{rcl}\mathrm{Paid}\mathrm{in}\mathrm{capital}\mathrm{in}\mathrm{excess}\mathrm{of}\mathrm{par}& =& \$3,911,111-\$5,00,000-\$156,444\\ & =& \$3,254,667\end{array}$

Explaining the best method

One is not superior to the other. The approach used is determined by the relative dependability of the valuation of stocks and bonds. This question is intended to elicit some thinking and conversation.