Chapter 10, Problem 5PA

a)

To determine

Prepare a journal entry to record the issuance of the bonds on August 1, 2018.

Explanation of Solution

Bonds: Bonds are long-term promissory notes that are issued by a company while borrowing money from investors to raise fund for financing the operations.

Prepare a journal entry to record the issuance of the bonds on August 1, 2018:

Date	Account title and Explanation	Post Ref.	Debit ($)	Credit ($)
August 1, 2018	Cash		10,250,000
	Bonds payable			10,000,000
	Bonds interest payable (1)			250,000
	(To record the issuance of bonds and 3 months accrued interest)

Table (1)

• Cash (asset) is increased by $10,250,000. Thus, it is debited.
• Bonds payable (liability) is increased by $10,000,000. Thus, it is credited.
• Bonds interest payable (liability) is increased by 250,000. Thus, it is credited.

Working note:

The bonds were issued on August 1, 2018, at 100 plus three months’ accrued interest. Interest rate is 10%.

Calculate the bonds interest payable (3 months accrued interest):

$\begin{array}{c}\text{3 months accrued Interest amount = Bond value}\times 10\text{\% }\times \left(3÷\text{12}\text{months}\right)\\ =\$10,000,000\times 10\text{\% }\times \left(3÷\text{12}\text{months}\right)\\ =\$250,000\end{array}$ (1)

b)

To determine

Prepare a journal entry to record the first semi-annual interest payment on the issued bond on November 1, 2018.

Explanation of Solution

Interest: Interest is an amount paid on the issue price of the bonds by the company at stated dates at stated rate of interest.

Prepare a journal entry to record the first semi-annual interest payment on the issued bond on November 1, 2018:

Date	Account title and Explanation	Post Ref.	Debit ($)	Credit ($)
November  1, 2018	Bonds interest payable(2)		250,000
	Bonds interest expense (3)		250,000
	Cash			500,000
	(To record the first semi-annual interest on bonds)

Table (1)

• Bonds interest payable (liability) is decreased by 250,000. Thus, it is debited.
• Bond interest expense (decreases the equity) is increased by $250,000. Thus, it is debited.
• Cash (asset) is decreased by $500,000. Thus, it is credited.

Working note:

The bonds are dated May 1, 2018. The bonds were issued on August 1, 2018, at 100 plus three months’ accrued interest. Interest rate is 10%. May to July is 3 months; August to October is 3 months (interest incurred period).

Calculate the bonds interest payable (3 months accrued interest):

$\begin{array}{c}\text{3 months accrued Interest amount = Bond value}\times 10\text{\% }\times \left(3÷\text{12}\text{months}\right)\\ =\$10,000,000\times 10\text{\% }\times \left(3÷\text{12}\text{months}\right)\\ =\$250,000\end{array}$ (2)

Calculate the bonds interest payable

$\begin{array}{c}\text{Interest amount = Bond value}\times 10\text{\% }\times \left(3÷\text{12}\text{months}\right)\\ =\$10,000,000\times 10\text{\% }\times \left(3÷\text{12}\text{months}\right)\\ =\$250,000\end{array}$ (3)

c)

To determine

Prepare a journal entry to record interest expense accrued through year-end on December 31, 2018.

Explanation of Solution

Accrued expenses: Accrued expenses are the expenses that have been incurred but have not been paid yet. These accrued expenses create accrued liabilities. For the portion of payment made, accrued liabilities would be reduced by way of passing an adjusting entry.

Example: Accrued salaries expense and accrued interest expense.

Prepare a journal entry to record interest expense accrued through year-end on December 31, 2018:

Date	Account title and Explanation	Post Ref.	Debit ($)	Credit ($)
December  31, 2018	Bonds interest expense		166,667
	Bonds interest payable (4)			166,667
	(To record the issuance of bonds and 2 months accrued interest)

Table (1)

• Bond interest expense (decreases the equity) is increased by $166,667. Thus, it is debited.
• Bonds interest payable (liability) is increased by 166,667. Thus, it is credited.

Working note:

Calculate the accrued interest (2 months accrued interest):

$\begin{array}{c}\text{2 months accrued Interest amount = Bond value}\times 10\text{\% }\times \left(2÷\text{12}\text{months}\right)\\ =\$10,000,000\times 10\text{\% }\times \left(2÷\text{12}\text{months}\right)\\ =\$166,667\end{array}$ (4)

d)

To determine

Prepare a journal entry to record the second semi-annual interest payment on May 1, 2019.

Explanation of Solution

Prepare a journal entry to record the second semi-annual interest payment on the issued bonds on May 1, 2019:

Date	Account title and Explanation	Post Ref.	Debit ($)	Credit ($)
May  1, 2019	Bonds interest payable(4)		166,667
	Bonds interest expense (5)		333,333
	Cash			500,000
	(To record the first semi-annual interest on bonds)

Table (1)

• Bonds interest payable (liability) is decreased by 166,667. Thus, it is debited.
• Bond interest expense (decreases the equity) is increased by $333,333. Thus, it is debited.
• Cash (asset) is decreased by $500,000. Thus, it is credited.

Working note:

In the second semi-annual interest payment, 2 months interest is recorded as accrued interest for a year end adjustment. This adjustment entry is reversed and interest expense is calculated for remaining 4 months (January to April).

Calculate the bonds interest expense:

$\begin{array}{c}\text{Interest amount = Bond value}\times 10\text{\% }\times \left(4÷\text{12}\text{months}\right)\\ =\$10,000,000\times 10\text{\% }\times \left(3÷\text{12}\text{months}\right)\\ =\$333,333\end{array}$ (5)

e)

To determine

Find the prevailing market rate of interest on the date that the bonds were issued and explain the same.

Explanation of Solution

10% is the prevailing market rate of interest on the date that the bonds were issued. The reason for it is the bonds were issued at par ($100) and the market rate had to have equalled the contract interest rate printed on the bonds.