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EXERCISE 16-1

(a) Market value of bonds without warrants $285,000


($300,000 X .95)
Market value of warrants (300 X 25 X $2) 15,000
Total market value $300,000

$285,000
X $312,000 = $296,400 Value assigned to bonds
$300,000

$15,000 Value assigned to warrants


$300,000 X $312,000 = $15,600

Cash ($300,000 X 1.04) .......................... 312,000


Bonds Payable ............................... 296,400
Contributed Surplus—Stock Warrants 15,600

Although the incremental (or residual) method could have been


used in this case, the proportional method has been used because
the fair value of the bonds and warrants were available.

(b) Cash ($10,000,000 X .97) ....................... 9,700,000


Bonds Payable ................................ 9,300,000
Contributed Surplus—
Conversion Rights ..................... 400,000
The incremental/residual method has been used in this case.

(c) Cash............................... ........................ . 19,600,000


Bonds Payable ................................ 18,400,000
Contributed Surplus—Stock Warrants 1,200,000
Value of bonds plus warrants
($20,000,000 X .98) $19,600,000
Value of warrants
(200,000 X $6) 1,200,000
Value of bonds $18,400,000
The incremental/residual method has been used in this case.
EXERCISE 16-1 (Continued)

(d) Expense—Debt Retirement Cost .......... 63,279


Retained Earnings ................................. 1,721
Bonds Payable ....................................... 9,925,000
Contributed Surplus—
Conversion Rights .................... 270,000
Common Shares ............................. 10,195,000
Cash................................................. 65,000

$9,925,000 X $65,000 = $63,279


$10,195,000 Assigned to debt
*

$270,000 Assigned to equity


$10,195,000 X $65,000 = $1,721

* [($10,000,000 - $75,000) + $270,000]

(e) Market value of bonds without warrants $475,000


($500,000 X .95)
Market value of warrants (500 X $50) 25,000
Total market value $500,000

$475,000
$500,000 X $515,000 = $489,250 Value assigned to bonds

$25,000 Value assigned to warrants


$500,000 X $515,000 = $25,750

Cash ($500,000 X 1.03) .......................... 515,000


Bonds Payable ............................... 489,250
Contributed Surplus—Stock Warrants 25,750
EXERCISE 16-10

SANDS CORP.
Journal Entry
September 1, 2008

Cash ($5,304,000 + $117,000) ........................ 5,421,000


Bonds Payable—Schedule 1.................. 5,252,000
Contributed Surplus—Stock Warrants—
Schedule 1........................................... 52,000
Bond Interest Expense—Schedule 2..... 117,000
(To record the issuance of the bonds)

Schedule 1
Premium on Bonds Payable and Value of Stock Warrants
Sales price (5,200 X $1,000 X 1.02) $5,304,000
Deduct value assigned to stock warrants
(5,200 X 2 = 10,400 X $5) 52,000
Bonds payable $5,252,000

Schedule 2
Accrued Bond Interest to Date of Sale
Face value of bonds $5,200,000
Interest rate 9%
Annual interest $ 468,000

Accrued interest for 3 months – ($468,000 X 3/12) $ 117,000


EXERCISE 16-11

(a) Cash ($5,500,000 X 1.01) ....................... 5,555,000


Bonds Payable ($5,500,000 X .96) . 5,280,000
Contributed Surplus—Stock Warrants 275,000*
*$5,555,000 – ($5,500,000 X .96)

(b) Market value of bonds without warrants $5,280,000


($5,500,000 X .96)
Market value of warrants (5,500 X $40) 220,000
Total market value $5,500,000

$5,280,000
$5,500,000 X $5,555,000 = $5,332,800 Value assigned to bonds

$220,000
$5,500,000 X $5,555,000 = $222,200 Value assigned to warrants

Cash............................... ........................ . 5,555,000


Bonds Payable ............................... 5,332,800
Contributed Surplus—Stock Warrants 222,200

(c) The reason why Farhad Limited would add the warrants to
the bond is to add a ―sweetener‖ to the bond. The
sweetener provides an additional equity instrument to the
bondholder, which has value. In exchange for the added
value of the warrant, Farhad Limited might be able to
market the bond with a lower coupon rate or at a lower
discount or higher premium price. Overall the interest costs
on the bond are reduced. It is also possible that without the
addition of the warrant as a sweetener, investors would not
purchase the bonds. This would in turn not provide Farhad
with the necessary financing it wishes to obtain from the
bond issue.
PROBLEM 16-3

(a) The entry for the issuance of the notes on January 1, 2008:
The present value of the note is: $1,200,000 X .56743 (factor
for a single payment in 5 years at 12%) = $680,912 (Rounded
by $4).

Using a financial calculator:


PV $? Yields $680,912
I 12%
N 5
PMT $ 0
FV $ (1,200,000)
Type 0

Excel formula =PV(rate,nper,pmt,fv,type)

January 1, 2008
Cash ............................... ................................ 1,000,000
Notes Payable............................... ................. 680,912
Contributed Surplus—Stock Warrants.. 319,088
PROBLEM 16-3 (Continued)
(b)
The amortization schedule for the zero note is:

SCHEDULE FOR INTEREST AND DISCOUNT AMORTIZATION—


EFFECTIVE INTEREST METHOD
$1,200,000 NOTE ISSUED TO YIELD 12%
Cash Effective Discount Carrying
Date Interest Interest Amortized Amount
1/1/08 $ 680,912
12/31/08 $0 $ 81,709* $ 81,709 762,621**
12/31/09 0 91,515 91,515 854,136
12/31/10 0 102,496 102,496 956,632
12/31/11 0 114,796 114,796 1,071,428
12/31/12 0 128,572 128,572 1,200,000
Total $0 $519,088 $519 ,088

*$680,912 X 12% = $81,709


**$680,912 + $81,709 = $762,621

(c)
December 31, 2008
Interest Expense ........................................... 81,709
Notes Payable ......................................... 81,709
PROBLEM 16-5

When accounting for the conversion of bonds into common


shares, whether using the book value or the market value
methods, certain accounts will need to be relieved of their
proportionate carrying value in order to properly record the
conversion. Since the conversion took place immediately after an
interest date, there is no accrued interest nor amortization of
bond discount to record prior to the recording of the conversion.

Under the book value method, the pro-rata carrying value of the
Bonds Payable, and Contributed Surplus – Stock Options would
be removed and a corresponding net entry to Common Shares
would result. No gain or loss on redemption would result.

Under the market value method, the common shares would be


recorded at market value (their market value or the market value of
the bonds), the Contributed Surplus and Bonds Payable amounts
would be proportionately reduced, and a gain/credit or loss/debit
would result. Since the CBCA requires shares to be recorded at
their cash equivalent value, legal requirements would tend to
support this approach. The interesting question is whether the
resulting gain/credit or loss/debit would be treated as an operating
or capital transaction. If it was seen as arising from debt
extinguishment, it would be an operating item (gain or loss) and
recognized through the statement of income. If it was seen as part
of the process of issuing shares, it should be booked through
equity.