In its 2002 annual report to shareholders, Aon Corporation described its mandatorily redeemable preferred stock as follows:

Question:

In its 2002 annual report to shareholders, Aon Corporation described its mandatorily redeemable preferred stock as follows:
In January 1997, Aon created Aon Capital A, a wholly-owned statutory business trust, for the purpose of issuing mandatorily redeemable preferred capital securities (Capital Securities). The sole asset of Aon Capital A is $$726$ million aggregate principal amount of Aon’s 8.205% Junior Subordinated Deferrable Interest Debentures due January 1, 2027.
Aon Capital A issued $$800$ million of 8.205% Capital Securities in January 1997. The Capital Securities are subject to mandatory redemption on January 1, 2027 or are redeemable in whole, but not in part, at the option of Aon upon the occurrence of certain events. . . . During 2002, approximately $$98$ million of the Capital Securities were repurchased on the open market for $$87$ million, excluding accrued interest.

Aonss 2002 balance sheet showed the following amounts:

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Required:
1. Aon’ capital securities are forms of preferred stock. Assume that Aon Capital A (the trustee) issued the securities on January 1, 1997 for $$800$ million cash, the same day that Aon Corporation issued $$800$ million of its junior debentures to the trust. Describe the cash flows associated with these two transactions—that is, explain who received cash and who gave up cash in each case.
2. One year later (on December 31, 1997), Aon Corporation must pay 8.205% interest to debt holders, and Aon Capital A must pay an 8.205% dividend to preferred stockholders.
Describe the cash flows associated with each of these payments—that is, explain who received cash, who gave up cash, and how much cash was exchanged.
3. For financial reporting purposes, how will Aon Corporation show its cash interest payment on December 31, 19972 4. Why did Aon Corporation create Aon Capital A?
5. Why does Aon Corporation's 2002 balance sheet show the capital securities in the “mezzanine”
section between total liabilities and stockholders’ equity?
6. Aon Corporation is an insurance company, so most of its liabilities relate to insurance policy premiums and policy liabilities. The company’s debt includes Short-term borrowings and Notes payable. Compute Aon’s debt-to-equity ratio for 2002 assuming that the capital securities are treated as part of equity. Repeat the calculation, this time assuming that the capital securities are part of debt. Which debt-to-equity ratio provides the most accurate measure of the company’s true debt and equity position? Why?
[B] Cephalon Inc’s Zero-Coupon, Zero Yield-to-Maturity Convertible Notes In June 2003, 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. Here is what Cephalon said about the notes:
On June 11, 2003, 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).

« $$375.0$ million of Zero Coupon Convertible Subordinated Notes due June 15, 2023 .. . are convertible prior to maturity, subject to certain conditions described below, into shares of our common stock at a conversion price of $$56.50$ per share (a conversion rate of approximately 17.6691 shares per $$1,000$ principal amount of notes)... .
The Notes also contain a restricted convertibility feature that does not affect the conversion price of the notes but, instead, places restrictions on a holder’s ability to convert their notes into shares of our common stock (“conversion shares”). A holder may convert the notes if one or more of the following conditions is satisfied:
• if, on the trading day prior to the date of surrender, the closing sale price of our common stock is more than 120% of the applicable conversion price per share (the “conversion price premium’);
• if we have called the notes for redemption;
• if the average trading prices of the notes for a specified period is less than 100% of the average of the conversion values of the notes during that period... ;
• if we make certain significant distributions to our holders of common stock or we enter into specified corporate transactions.
Because oft he inclusion oft he restricted convertibility feature of the Notes, our diluted income per common share calculation does not give effect to the dilution from the conversion of the Notes until our share price exceeds the 20% conversion price premium or one of the other conditions above is satisfied.
Source: 10-Q filing for Cephalon Inc., June 2003.
Required:
1. What accounting entry did Cephalon make to record the proceeds received from issuing the notes on June 11, 2003? Over the next year, what other accounting entries (if any)
related to these notes did the company make?
2. The notes mature in 2023, approximately 20 years from the date they were issued. At a 6%
rate of annual interest, the present value of $$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 to record the proceeds received from issuing the notes on June 11, 2003? Over the next year, what other accounting entries (if any) related to these notes would the company make?
4. Describe Cephalon’ financial reporting advantages of issuing zero-coupon, zero yield-tomaturity 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?