[Anonymous]

Can someone please help me with the question below? Why are they calculating interest expense the way they do? I would think you would calculate interest expense by determining the book value of the bonds times the effective interest rate (5,000,000 less 120,000 discount remaining * 10% effective rate).

The following information is relevant to the computation of Chan Co.’s earnings per share to be disclosed on

Chan’s income statement for the year ending December 31:

Net income for 2002 is $600,000.

$5,000,000 face value 10-year convertible bonds outstanding on January 1. The bonds were issued four

years ago at a discount which is being amortized in the amount of $20,000 per year. The stated rate of

interest on the bonds is 9%, and the bonds were issued to yield10%. Each $1,000 bond is convertible into 20

shares of Chan’s common stock.

Chan’s corporate income tax rate is 25%.

Chan has no preferred stock outstanding, and no other convertible securities. What amount should be used as

the numerator in the fraction used to compute Chan’s diluted earnings per share assuming that the bonds are

dilutive securities?

a. $130,000

b. $247,500

c. $952,500

d. $1,070,000

Explanation

Choice “c” is correct. The numerator in the diluted EPS computation is equal to income available to common

shareholders plus the after-tax interest expense that would not have been incurred if the bonds had been

converted. Note that the company is using straight-line amortization rather than effective interest amortization.

Under straight-line amortization, interest expense of $470,000 is reported each period. The interest expense is

equal to the interest payment of $450,000 ($5,000,000 face x 9% stated rate) plus the discount amortization of

$20,000. Therefore, the numerator is calculated as:

Income available to common shareholders + Interest of dilutive securities

= $600,000 + [$470,000 x (1 – 25%)] = $600,000 + $352,500 = $952,500