Question

On January 1, 2017, Olson Corporation issued $6 million of 10-year, 7%, convertible debentures at 104. Investment bankers believe that the debenture would have sold at 102 without the conversion privilege. Interest is to be paid semi-annually on June 30 and December 31. Each $1,000 debenture can be converted into five common shares of Olson after December 31, 2018. On January 1, 2016, $400,000 of debentures is converted into common shares, and on March 31, 2019, an additional $400,000 of debentures is converted into common shares. Fair value of Olson’s common shares is $110 and $115 per share on January 1, 2019 and March 31, 2019, respectively. Accrued interest at March 31 will be paid on the next interest date. Bond premium is amortized on a straight-line basis. Olson follows ASPE.

a) Make the necessary journal entries for:

1. December 31, 2018

2. January 1, 2019

3. March 31, 2019

4. June 30, 2019

b) From the perspective of the debenture holders, why would they be motivated to wait for the conversion of the bonds into common shares? What are the risks involved in waiting and what could the bondholders ultimately give up by waiting too long?

Answer 1

a)
Date	Account Titles & Explanation	Debit	Credit
December 31, 2018	Bond Interest Expense	$   1,98,000.00
	Premium on Bonds Payable (($6,000,000 x 104%) - $6,000,000)/20 years	$      12,000.00
	Cash ($6,000,000 X 7% X 6/12)		$   2,10,000.00
2. January 1, 2019	Bonds Payable	$   4,00,000.00
	Premium on Bonds Payable ( see below)	$      12,800.00
	Common Stock [5 X $100 X ($400,000/$1,000)]		$   2,00,000.00
	Paid-in Capital in Excess of Par		$   2,12,800.00
Total Premium = $6,000,000 x 4%	$                                                                               2,40,000.00
Less: Premium amortized ($240,000 X 4/20)	$                                                                                  48,000.00
Balance on Jan 1,2019	$                                                                               1,92,000.00
Bonds converted ($400,000 ÷ $6,000,000)	6.67%
Premium on bonds Payable = 192000 x 6.67%	$                                                                                  12,800.00
3. March 31, 2019	Bond Interest Expense	$        6,600.00
	Premium on Bonds Payable (12800/8yrs x 3/12)	$           400.00
	Bond Interest Payable($400,000 X 7% X 3/12)		$        7,000.00
March 31, 2019	Bonds Payable	$   4,00,000.00
	Premium on Bonds Payable (12,800 - 400)	$      12,400.00
	Common Stock [5 X $100 X ($400,000/$1,000)]		$   2,00,000.00
	Paid-in Capital in Excess of Par		$   2,12,400.00
4. June 30, 2019	Bond Interest Expense	$   1,77,100.00
	Premium on Bonds Payable (190400/16 periods)	$      11,900.00
	Bond Interest Payable	$        7,000.00
	Cash ($6,000,000 - $800,000 X 7% x 6/12) + 7000		$   1,89,000.00
Original premium	$                                                                               2,40,000.00
2017 amortization	$                                                                                 -12,000.00
2018 amortization	$                                                                                 -12,000.00
Jan. 1, 2019 write-off	$                                                                                 -12,800.00
Mar. 31, 2019 amortization	$                                                                                      -400.00
Mar. 31, 2019 write-off	$                                                                                 -12,400.00
Balance	$                                                                               1,90,400.00
b)
If the market value of the underlying common stock increases above the conversion price, the debentureholder either through conversion receives the benefits of appreciation. The risks involved in waiting is the value of the underlying company stock not increase, the debentureholder could nevertheless expect to receive the principal and lower interest.