Chapter 14, Problem 21E

1.a.

To determine

Prepare journal entry to record the conversion of bonds under book value method.

Explanation of Solution

Induced Conversion:

Induced conversion is a method wherein, the convertible bonds issued by the company are converted into common stock in order to reduce interest costs or for increasing the debt-to-equity ratio of the company.

Prepare journal entry to record the conversion of bonds under the book value method.

Date	Account Titles and Explanation	Debit	Credit
July 3, 2017	Bonds payable	$500,000
	Discount on bonds payable		$7,400
	Common stock (1)		$50,000
	Additional paid in capital - Common stock (balancing figure)		$442,600
	(To record conversion of bonds)

Table (1)

• Bonds payable is a liability, and it is decreased. Therefore, debit bonds payable account for $500,000.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $7,400.
• Common stock is a component of stockholders’ equity, and it is increased. Therefore, credit common stock account for $50,000.
• Additional paid in capital on common stock is a component of stockholders’ equity, and it is increased. Therefore, credit additional paid in capital on common stock account for $442,600.

Working notes:

(1)Calculate common stock.

$\begin{array}{c}\text{Common stock =}\left(\begin{array}{l}\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \text{Convertible }\\ \text{common shares}\times \text{Face value}\text{per share}\end{array}\right)\\ \text{=}\left(\frac{\$500,000}{\$1,000}\right)\times 20\text{Common shares}\times \text{\$5}\\ \text{=}500\times 20\times \$5\\ =\$50,000\end{array}$

b.

To determine

Prepare journal entry to record the conversion of bonds under the market value method.

Explanation of Solution

Prepare journal entry to record the conversion of bonds under the market value method.

Date	Account Titles and Explanation	Debit	Credit
July 3, 2017	Bonds payable	$500,000
	Loss on Conversion (balancing figure)	$27,400
	Discount on bonds payable		$7,400
	Common stock (2)		$50,000
	Additional paid - In capital on Common stock (3)		$470,000
	(To record conversion of bonds)

Table (2)

• Bonds payable is a liability, and it is decreased. Therefore, debit bonds payable account for $500,000.
• Loss on conversion is a component of stockholders’ equity, and it increases expense accounts. Therefore, debit loss on conversion account for $27,400.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $7,400.
• Common stock is a component of stockholders’ equity, and it is increased. Therefore, credit common stock account for $50,000.
• Additional paid in capital on common stock is a component of stockholders’ equity, and it is increased. Therefore, credit additional paid in capital on common stock account for $470,000.

Working notes:

(2)Calculate common stock.

$\begin{array}{c}\text{Common stock =}\left(\begin{array}{l}\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \text{Convertible }\\ \text{common shares}\times \text{Face value}\text{per share}\end{array}\right)\\ \text{=}\left(\frac{\$500,000}{\$1,000}\right)\times 20\text{Common shares}\times \text{\$5}\\ \text{=}500\times 20\times \$5\\ =\$50,000\end{array}$

Calculate additional paid in capital – common stock.

(3)Calculate common stock.

$\begin{array}{c}\begin{array}{l}\text{Additional paid in capital}\\ \text{ -}\text{common stock}\end{array})\text{ =}\left(\begin{array}{l}\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \text{Convertible }\\ \text{common shares}\times \left(\begin{array}{l}\text{Market value per share }\\ -\text{Face value}\text{per share}\end{array}\right)\end{array}\right)\\ \text{=}\left(\frac{\$500,000}{\$1,000}\right)\times 20\text{Common shares}\times \left(\$52-\$5\right)\\ \text{=}500\times 20\times \$5\\ =\$470,000\end{array}$

2.

To determine

Calculate the company’s debt equity ratio under each alternative method described in the chapter 6. Assume the company other liabilities are $2,000,000 and shareholders’ equity before conversion is $3,000,000.

Explanation of Solution

Compute debt to equity ratio before the conversion.

$\begin{array}{c}\text{Debt to equity ratio =}\frac{\text{Total liabilites}}{\text{Total stockholders'}\text{equity}}\\ =\frac{\$2,492,600}{\$3,000,000}\\ =0.831\end{array}$

Compute debt to equity ratio after conversion accounted for with book value method.

$\begin{array}{c}\text{Debt to equity ratio =}\frac{\text{Total liabilites}}{\text{Total stockholders'}\text{equity}}\\ =\frac{\$2,492,600-\$492,600}{\$3,000,000+\$492,600}\\ =\frac{\$2,000,000}{\$3,492,600}\\ =0.573\end{array}$

Compute debt to equity ratio after conversion computed for with market value method.

$\begin{array}{c}\text{Debt to equity ratio =}\frac{\text{Total liabilites}}{\text{Total stockholders'}\text{equity}}\\ =\frac{\$2,492,600-\$492,600}{\$3,000,000+\$520.000-\$27,400}\\ =\frac{\$2,000,000}{\$3,492,600}\\ =0.573\end{array}$

3.

To determine

Prepare journal entry to record issuance of bonds, assume the company uses IFRS and issued the bonds for $487,500 on 2^nd July 2021.

Explanation of Solution

Date	Account Titles and Explanation	Debit	Credit
July 2, 2021	Cash	$487,500
	Bonds payable		$465,000
	Share premium conversion equity (4)		$22,500
	(To record issuance of bonds payable)

Table (3)

• Cash is a current asset, and it is increased. Therefore, debit cash account for $487,500.
• Bonds payable is a liability, and it is increased. Therefore, credit bonds payable account for $465,000.
• Share premium conversion equity is a component of stockholders’ equity, and it is increased. Therefore, credit share premium conversion equity account for $22,500.

Working note:

(4)Calculate share premium conversion equity.

$\begin{array}{c}\begin{array}{l}\text{Share premium }\\ \text{conversion equity }\end{array})\text{=}\left(\frac{\text{Bonds payable}}{\text{Number of convertible bonds}}\times \left(\begin{array}{l}\text{Fair value of }\\ \text{conversion option}\end{array}\right)\right)\\ \text{=}\left(\frac{\$500,000}{\$1,000}\right)\times \$45\\ \text{=}500\times \$45\\ =\$22,500\end{array}$