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Bond Conversion and Amortization Errors

1. Nast Co. issued bonds at a discount that it amortized incorrectly using the straight-line method instead of the effective interest method, overstating the carrying amount at December 31, 20x1 by ₱3,000. On the maturity date there would be no effect. 2. York Co. converted bonds into shares, recording a share premium of ₱1,250,000 upon conversion when the carrying amount of bonds exceeded par value of shares. 3. Witt Corp. recorded no gain or loss on conversion of convertible bonds into shares at fair value. 4. Ray Corp. issued bonds with detachable warrants, which were issued at a discount of

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2K views2 pages

Bond Conversion and Amortization Errors

1. Nast Co. issued bonds at a discount that it amortized incorrectly using the straight-line method instead of the effective interest method, overstating the carrying amount at December 31, 20x1 by ₱3,000. On the maturity date there would be no effect. 2. York Co. converted bonds into shares, recording a share premium of ₱1,250,000 upon conversion when the carrying amount of bonds exceeded par value of shares. 3. Witt Corp. recorded no gain or loss on conversion of convertible bonds into shares at fair value. 4. Ray Corp. issued bonds with detachable warrants, which were issued at a discount of

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Randelle James Fiesta
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  • Activity Chapter 5
  • Conversion of Bonds Activity

ACTIVITY CHAPTER 5

1. On January 2, 20x1, Nast Co. issued 8% bonds with a face amount of ₱1,000,000
that mature on January 2, 20x7. The bonds were issued to yield 12%, resulting in a
discount of ₱150,000. Nast incorrectly used the straight-line method instead of the
effective interest method to amortize the discount. How is the carrying amount of the
bonds affected by the error?
Ans. At Dec. 31, 20x1-overstated/At Jan. 2, 20x7-no effect
Solution:

EFFECT ON DECEMBER 31, 20X1:


Using straight line method:

Discount on bonds - 1/2/x1 150,000


Divide by: Term 6
Annual amortization of discount 25,000

Discount on bonds - 1/2/x1 150,000


Amortization - 20x1 (25,000)
Discount on bonds - 12/31/x1 125,000

Face amount 1,000,000


Discount on bonds - 12/31/x1 (125,000)
Carrying amount - 12/31/x1 875,000

Using effective interest method:

Date Interest expense Payments Amortization Present Value


1/2/x1 850,000
12/31/x1 102,000 80,000 22,000 872,000

Carrying amounts - 12/31/x1:


Straight line (erroneous) 875,000
ffective interest method 872,000
Difference – overstatement (3,000)

EFFECT ON JANUARY 2, 20X7:


On January 2, 20x7, maturity date, there will be NO EFFECT of the error on the carrying amount of
the bonds because on this date, the discount would have been fully amortized under both the
straight line method and the effective interest method.

2. On July 1, 2003, after recording interest and amortization, York Co.


converted ₱1,000,000 of its 12% convertible bonds into 50,000 shares of ₱1 par
value ordinary share. On the conversion date the carrying amount of the
bonds was ₱1,300,000, the fair value of the bonds was ₱1,400,000, and York’s
ordinary share was publicly trading at ₱30 per share. What amount of share
premium should York record as a result of the conversion?
Ans. 1,250,000
Solution:

Carrying amount of bonds converted 1,300,000


Par value of shares issued (50,000 x 1) (50,000)
Share premium 1,250,000

3. On April 30, 20x5, Witt Corp. had outstanding 8%, ₱1,000,000 face amount,
convertible bonds maturing on April 30, 20x9. Interest is payable on April 30
and October 31. On April 30, 20x5, all these bonds were converted into 40,000
shares of ₱20 par ordinary share. On the date of conversion:
• Unamortized bond discount was ₱30,000.
• Each bond had a fair value of ₱1,080.
• Each share of stock had a fair value of ₱28.
What amount should Witt record as a loss on conversion of bonds?
Ans. 0
Solution:
No gain or loss is recognized when convertible bonds are converted into equity instrument.

4. Ray Corp. issued bonds with a face amount of ₱200,000. Each ₱1,000 bond
contained detachable stock warrants for 100 shares of Ray's common stock.
Total proceeds from the issue amounted to ₱240,000. The fair value of each
warrant was ₱2, and the fair value of the bonds without the warrants was
₱196,000. The bonds were issued at a discount of
Ans. 4,000
Solution:
Fair value of bonds without the warrants 196,000
Face amount of bonds 200,000
Discount on bonds (4,000)

5. On June 30, 20x9, King Co. had outstanding 9%, ₱5,000,000 face value
bonds maturing on June 30, 2x14. Interest was payable semiannually every
June 30 and December 31. On June 30, 20x9, after amortization was recorded
for the period, the unamortized bond premium and bond issue costs were
₱30,000 and ₱50,000, respectively. On that date, King acquired all its
outstanding bonds on the open market at 98 and retired them. At June 30,
20x9, what amount should King recognize as gain on redemption of bonds?
Ans. 80,000
Solution:
Redemption price (5M x 98%) 4,900,000
Less: Carrying amount of bonds:
Face amount 5,000,000
Unamortized premium 30,000
Unamortized issue costs (50,000) 4,980,000
Gain on retirement 80,000

Common questions

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Factors to assess include the market conditions at the time of conversion or retirement, the current interest rates, and the financial performance of the issuing company. Additionally, the comparison of the carrying value and fair market value is critical, as is evaluating any economic benefits or costs related to conversions or retirements .

By the maturity date, the discount on Nast Co.'s bonds is fully amortized regardless of whether the straight-line or effective interest method is used. Thus, there is no impact on the carrying amount of the bonds at maturity, January 2, 20x7, from the choice of amortization method .

Unamortized bond discounts are deducted from the bonds' face value at conversion, impacting the carrying amount at the conversion date. For Witt Corp., the unamortized bond discount of ₱30,000 reduces the carrying amount of the bonds prior to their conversion into shares .

The erroneous use of the straight-line method causes the carrying amount of the bonds to be overstated by ₱3,000 at December 31, 20x1. The straight-line method resulted in a carrying amount of ₱875,000, while the effective interest method results in a carrying amount of ₱872,000, indicating an overstatement due to the method used .

No gain or loss is recognized when convertible bonds are converted into equity instruments because the transaction is recorded at the carrying amount of the bonds. As a standard accounting practice, conversion from debt to equity does not create a gain or loss for the issuing entity .

Detachable warrants increase the total proceeds from the bond issuance, as their fair value contributes an add-on to the intrinsic value of the bonds themselves. In Ray Corp.’s case, the total proceeds (₱240,000) reflect not just the bonds' fair value without warrants (₱196,000) but also the value of the attached warrants, contributing to the overall financial structuring of the issue .

Unamortized issue costs are subtracted from the face value when determining the carrying amount of the bonds, reducing the total amount used for gain calculation. In King Co.'s scenario, these costs (₱50,000) offset against bond liabilities, affecting the net gain recognized upon redemption .

Share premium recognition is necessary to reflect the difference between the carrying amount of the bonds and the par value of the shares issued, acknowledging the surplus contributed by conversion. This premium indicates additional financial strength gained from capital conversion, beyond mere par value equity recording .

York Co. should determine the share premium by subtracting the par value of the shares issued from the carrying amount of the bonds converted. In this case, with a carrying amount of ₱1,300,000 for the bonds and par value of shares issued amounting to ₱50,000, the share premium recorded should be ₱1,250,000 .

The gain on redemption is calculated by taking the difference between the carrying amount of the bonds and the redemption price. The carrying amount is ₱4,980,000, calculated as face value (₱5,000,000) plus unamortized premium (₱30,000) minus unamortized issue costs (₱50,000). The redemption price is ₱4,900,000 (₱5,000,000 x 98%), resulting in a gain of ₱80,000 .

ACTIVITY CHAPTER 5 1. On January 2, 20x1, Nast Co. issued 8% bonds with a face amount of ₱1,000,000 that mature on January
Ans. 1,250,000 Solution: Carrying amount of bonds converted 1,300,000 Par value of shares issued (50,000 x 1)

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