Question

On January 1, 2019, Garner issued 10-year, $200,000 face value, 6% bonds at par. Each $1,000 bond is convertible into 30 shares of Garner $2 par value common stock. The company has had 10,000 shares of common stock (and no preferred stock) outstanding throughout its life. None of the bonds have been converted as of the end of 2020. (Ignore all tax effects.)

Requirement 1: Accounting

1. Prepare the journal entry Garner would have made on January 1, 2019, to record the issuance of the bonds.
2. Garner’s net income in 2020 was $30,000 and was $27,000 in 2019. Compute basic and diluted earnings per share for Garner for 2020 and 2019.
3. Assume that 75% of the holders of Garner’s convertible bonds convert their bonds to stock on June 30, 2021, when Garner’s stock is trading at $32 per share. Garner pays $50 per bond to induce bondholders to convert. Prepare the journal entry to record the conversion.

Requirement 2: Analysis

Show how Garner will report income and EPS for 2020 and 2019. Briefly discuss the importance of GAAP for EPS to analysts evaluating companies based on price-earnings ratios. Consider comparisons for a company over time, as well as comparisons between companies at a point in time.

Answer 1

(a) Journal entry for issue of bonds

2019 January 1

Bank a/c Dr To 6% bonds payable

$200,000

$200,000

(b)

		2020	2019
	Earnings	$30,000	$27,000
	No of Shares	10000	10000
	Basic EPS (earning/no. of shares above)	$3	$2.7
	No of shares on conversion of bonds into equity
	Existing shares	10000	10000
	Converted shares	6000	6000
	200,000/1000*30
	No of shares	16000	16000
	Diluted EPS (earning/no. of shares above)	1.875	1.6875

(c) 75% of the convertible bonds = 200,000/1000 * 75%

= 150 bonds

converted into = 150 * 30 shares

= 4500 shares

existing shares = 10000 shares

total shares after conversion = 14,500 shares

face value of converted shares = 4500*2 = $9000

share premium = (32-2) * 4500

= $135,000

Journal entry

June 30, 2021

6% convertible bond a/c Dr. To share cap To share premium To profit & loss

$150,000

$9,000 $135,000 $6,000

Requirement 2

Income for the year 2019  and 2020 will be decreased equivalent to an annual interest of the bonds by $12,000 ($200,000 x 6%), at the same time, the EPS will also decrease by $1.20/share ($12,000/10,000 shares). This shall be reported in the income statement of Garner.

EPS standards are important to analysts who rely on reported earnings per share figures for their analysis. A price-earnings ratio is a price per share divided by the earnings per share. Analysts use the P/E ratio in a variety of analyses, including the evaluation of earnings quality and the assessment of a company's growth prospects. The more variation in how companies compute EPS, the less comparable are EPS figures across companies and across time for the same companies.