Chapter 14, Problem 14.20P

Convertible bonds; zero coupon; potentially convertible into cash; FASB codification research

• LO14–5

The 2018 annual report of MLS Corporation included the following disclosure note:

Note 10: Borrowings (in part)

Convertible Debt

On June 15, 2018, we issued $125 million of zero coupon convertible unsecured debt due on June 15, 2020 in a private placement offering, priced to yield 1.85%. Proceeds from the offering were $118.3115 million. Initially, each $1,000 principal amount of bonds was convertible into 30 shares of MLS common stock at a conversion price of $35 per share.

The bonds are convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the bonds and pay or deliver cash, shares of our common stock, or a combination of cash and shares of our common stock, at our election.

Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the bonds in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $118.3 million were allocated between debt for $117.2 million and shareholders’ equity for $1.1 million with the portion in shareholders’ equity representing the fair value of the option to convert the debt.

Required:

1. Prepare the journal entry that was recorded when the bonds were issued on June 15, 2018.

2. What amount of interest expense, if any, did MLS record the first year the bonds were outstanding?

3. Normally under U.S. GAAP, we record the entire issue price of convertible debt as a liability. However, MLS separately recorded the liability and equity components of the notes. Why?

4. Obtain the relevant authoritative literature on classification of debt expected to be financed using the FASB’s Codification Research System. You might gain access from the FASB website (www.fasb.org), from your school library, or some other source. Determine the criteria for reporting debt potentially convertible into cash. What is the specific codification citation that MLS would rely on in applying that accounting treatment?