On January 2,2016,L Co.issued at face value $20,000 of 4% bonds convertible in total into 1,000 shares of L's common stock.No bonds were converted during 2016.
Throughout 2016,L had 1,000 shares of common stock outstanding.L's 2016 net income was $2,000.L's income tax rate is 50%.
No potential common shares other than the convertible bonds were outstanding during 2016.
L's diluted earnings per share for 2016 would be:
A)$1.00.
B)$1.20.
C)$1.40.
D)$2.00.

Question

Quizplus · Accepted Answer

Since the convertible bonds were not converted, they are considered potential common shares. To calculate diluted earnings per share, we need to assume that the bonds were converted and calculate the impact on earnings per share.

First, we need to calculate the interest expense on the bonds:
$20,000 x 4% = $800

Since the bonds are convertible into 1,000 shares, we need to calculate the impact on earnings per share if the bonds were converted:
$2,000 / (1,000 + 1,000) = $1.00

However, since the bonds are convertible, L would no longer be paying the $800 in interest expense, so we need to adjust for this:
$2,000 - $800 x 50% = $1,100

Finally, we calculate diluted earnings per share:
($2,000 - $800 x 50% + $800) / (1,000 + 1,000) = $1.20