Blackman Corp. (a fictional company) issues 10-year convertible notes at par for $10,000 on December 31, 20X1. The notes mature in 10 years and are convertible into 400 shares of Blackman common stock at any time after January 1, 20X6. Interest is paid annually at the end of each year at an interest rate of 2% of the principal amount (i.e., $200 per year). If investors exercise the conversion feature, Blackman either can deliver shares of common stock or make a cash payment equal to the market value of those shares. In the absence of the conversion feature, investors would have demanded a 6% return on a Blackman loan of similar terms.

Required:

[A] Using the bifurcation approach required by U.S. GAAP in this setting:

1. What are the fair values of the debt and equity components of Blackman’s convertible notes? Round to the nearest dollar.

2. What journal entry would Blackman make to record the issuance of the convertible notes?

3. How much interest expense would Blackman recognize in 20X2? In 20X3?

4. What would be the carrying value of the convertible notes as of December 31, 20X3?

5. Suppose investors opt to exercise the conversion feature on January 1, 20X7, when Blackman common stock is trading at $30 per share. What is the cash settlement amount, and how much of this amount should be assigned to repurchasing the debt versus settlement of the conversion (equity) option? Round to the nearest dollar and assume that Blackman’s borrowing cost at the conversion date is 5%.

6. What journal entry would Blackman make to record cash-settlement conversion of the notes on January 1, 20X7?

[B] Using U.S. GAAP for traditional convertible debt instruments:

1. What journal entry would Blackman make to record issuance of the convertible notes?

2. How much interest expense would Blackman recognize in 20X2? In 20X3?

3. What would be the carrying value of the convertible notes as of December 31, 20X3?

4. Suppose investors opt to exercise the conversion feature on January 1, 20X7, when

Blackman common stock is trading at $30 per share. What journal entry would Blackman make to record cash-settlement conversion of the notes on January 1, 20X7? Round to the nearest dollar and assume that Blackman’s borrowing cost at the conversion date is 5%.