On February 1, 2010, Aubrey Company sold its 5-year, $1,000 par value, 9% bonds,
ID: 2462116 • Letter: O
Question
On February 1, 2010, Aubrey Company sold its 5-year, $1,000 par value, 9% bonds, which were convertible at the option of the investor into Aubrey Company common stock at a ratio of 10 shares of common stock for each bond. Aubrey sold the convertible bonds at a discount. Interest is payable annually each February 1. On February 1, 2016, Mel Company, an investor in the Aubrey Company convertible bonds, tendered 1,000 bonds for conversion into 10,000 shares of Aubrey Company common stock, which had a market value of $110 per share at the date of the conversion.
On May 1, 2016, Aubrey sold its 10-year, $1,000 par value, 10% nonconvertible term bonds dated April 1, 2016. Interest is payable semiannually, and the first interest payment date is October 1, 2016. Due to market conditions, the company sold the bonds at an effective interest rate (yield) of 12%.
1. Explain how Aubrey accounts for the conversion of the convertible bonds into common stock under both the book value and market value methods. Discuss the rationale for each method.
2. Were the nonconvertible term bonds sold at par, at a discount, or at a premium? Discuss the rationale for your answer.
3. Identify and discuss the effects on Aubrey's 2016 income statement associated with the nonconvertible term bonds
Explanation / Answer
1.
Journal entry for conversion of bonds under Book value method
Date
Account title
Debit
Credit
February 1,2016
Bonds payable
$1,000,000
Common stock
$1,000,000
Journal entry for conversion of bonds under Market value method
Date
Account title
Debit
Credit
February 1,2016
Bonds payable
$1,000,000
Loss on redemption of bonds payable
$100,000
Common stock
$1,100,000
2.
Effective interest at the time of issue of non convertible bonds is more than the stated interest on bonds. It means that the interest provided by the bonds is less than the interest provided by other securities. Hence, Non convertible bonds are issued at discount.
3.
Semi-annual interest payments = $1,000 * 0.10 *1/2 = $50
Present value of interest payments = $50 (1-1/1.0610)/0.06 =$50(1-0.5584)/0.06 = $368
Present value of face amount of bonds = $1,000/1.0610 = $1,000 / 1.7908 = $558.41
Issue price of bonds = Present value of interest payments + Present value of face amount of bonds
= $368 + $558.41 = $926.41
Discount in issue of bonds = $1,000 - $968.41 = $73.59
Amount to be charged to income statement for the year 2016 = $926.41 * 0.06 = $55.58
Date
Account title
Debit
Credit
February 1,2016
Bonds payable
$1,000,000
Common stock
$1,000,000
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