Cephalon Inc. issued $750 million of zero-coupon convertible notes. Because the notes were issued at par, meaning that Cephalon received $750 million cash for the notes, they have a zero yield-to-maturity. Settlement in cash upon conversion is not permitted. Here is what Cephalon said about the notes:

We issued and sold in a private placement $750.0 million of Zero Coupon Convertible Subordinated Notes (the “Notes”). The interest rate on the Notes is zero and the Notes will not accrete interest. . . . The Notes are subordinate to our existing and future senior indebtedness. The Notes were issued in two tranches and have the following salient terms:

• $375.0 million of Zero Coupon Convertible Subordinated Notes due June 15, 2023 . . . are convertible prior to maturity, subject to certain conditions described below, into shares of our common stock at a conversion price of $59.50 per share (a conversion rate of approximately 16.8067 shares per $1,000 principal amount of notes). . . .

The Notes also contain a restricted convertibility feature that does not affect the conversion price of the notes but, instead, places restrictions on a holder’s ability to convert their notes into shares of our common stock (“conversion shares”). A holder may convert the notes if one or more of the following conditions is satisfied:

• if, on the trading day prior to the date of surrender, the closing sale price of our common stock is more than 120% of the applicable conversion price per share (the “conversion price premium”);

• if we have called the notes for redemption;

• if the average trading prices of the notes for a specified period is less than 100% of the average of the conversion values of the notes during that period . . . ;

• if we make certain significant distributions to our holders of common stock or we enter into specified corporate transactions.

Because of the inclusion of the restricted convertibility feature of the Notes, our diluted income per common share calculation does not give effect to the dilution from the conversion of the Notes until our share price exceeds the 20% conversion price premium or one of the other conditions above is satisfied.

Required:

1. Cephalon is a U.S. company. What accounting entry did Cephalon make to record the $750 million proceeds received from issuing the notes? Over the next year, what other accounting entries (if any) related to these notes did the company make?

2. The notes mature in 2023, approximately 20 years from the date they were issued. At a 6% rate of annual interest, the present value of $1,000 to be received 20 years from today is only $311.805. (You might want to verify this conclusion.) Suppose that Cephalon’s true cost of borrowing money is 6% per year. How much did note holders pay for Cephalon debt, and how much did they pay for the option to convert the notes into shares of common stock?

3. Suppose that Cephalon separated the notes into debt and equity components and then recorded each component separately. What accounting entry would the company make on the issue date to record the proceeds received from issuing the notes? Over the next year, what other accounting entries (if any) related to these notes would the company make? 

4. Describe Cephalon’s financial reporting advantages of issuing zero-coupon, zero yield-to-maturity notes rather than a more traditional debt instrument. Why aren’t the notes included in the company’s computation of diluted earnings per share? 

5. If Cephalon were to issue those same notes today, would it still be able to use the accounting entries outlined in your answer to requirement 1?