Question

On January 1, 2015, when its $30 par value common stock was selling for $80 per share, a corporation issued $10 million of 10% convertible debentures due in 10 years. The conversion option allowed the holder of each $1,000 bond to convert it into six shares of the corporation’s $30 par value common stock. The debentures were issued for $11 million. At the time of issuance, the present value of the bond payments was $8.5 million, and the corporation believes the difference between the present value and the amount paid is attributable to the conversion feature. On January 1, 2016, the corporation’s $30 par value common stock was split 3 for 1. On January 1, 2017, when the corporation’s $10 par value common stock was selling for $90 per share, holders of 40% of the convertible debentures exercised their conversion options. The corporation uses the straight-line method for amortizing any bond discounts or premiums.
Required:

1. Prepare the journal entry to record the original issuance of the convertible debentures.
2. Prepare the journal entry to record the exercise of the conversion option, using the book value method.

There should be two general journals. one with 3 accounts on jan 1 2015 and one on jan 1 2017 with 4 accounts.

Answer 1

1. Journal entry for original issuance of convertible debentures:

Bank A/c Dr. 11,000,000

To 10% convertible debentures A/c 8,500,000

To share premium-conversion A/c 2,500,000 (Balancing figure)

2. Journal entry for exercise of conversion option

10% Convertible debentures A/c Dr. 4,000,000

Share premium-conversion A/c Dr. 1,000,000

To common stock A/c(72,000 shares @ 10$) 240,000

To additional paid in capital A/c (balancing figure)4,760,000

Explanations for the above 2 journal entries:

1. The debentures are recorded in the books taking into consideration their present value on the date of issuance. The balancing figure is attributed to the share premium conversion account which is to be subsequently reversed on conversion.

2. The company has given a conversion ratio of 6:1. However, the same was done when the par value of the stock was $30 per share. Since the same was split in the next year in the ratio of 3:1, each convertible debeneture will now fetch 18 shares. (18:1). 40% of the debenture holders(4,000 debentures) are being converted to stock. Therefore, the number of shares issued would be 4,000 x 18 = 72,000. The par value of stock issued would be 720,000(72,000*10). Since the journal entry is to be recorded at book value, the debentures account needs to be debited to the extent of 4,000,000(4,000 @ 1,000$ per debenture) and share premium proportionate to the 4,000 debentures needs to be reversed. The excess amount is to be recorded as additional paid in capital.