Chapter 10, Problem 6AP

a)

To determine

Prepare the Adjusting entries at December 31, 2015, and the journal entry to record the payment of bond interest on March 1, 2016, under each of the following assumptions:

1. The bonds were issued at 98. (Round to nearest dollar.)

2. The bonds were issued at 101. (Round to nearest dollar.)

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.

Bond discount: Bond discount is the amount by which the selling price (or issue price or market price) of the bond is lower than the face value of the bond.

Bond premium: Bond premium is the amount by which the selling price (or issue price or market price) of the bond is more than the face value of the bond.

Prepare the adjusting entries at December 31, 2015, and the journal entry to record the payment of bond interest on March 1, 2016.

1. The bonds were issued at 98. (Round to nearest dollar.)

Date	Account title and Explanation	Post Ref.	Debit ($)	Credit ($)
December 31, 2015	Bond Interest Expense		2,693,334
	Discount on Bonds Payable			26,667
	Bond Interest Payable			2,666,667
	(Record the adjusting entry for the year end December 31, 2015)
March 1, 2016	Bond Interest Payable		2,666,667
	Bond Interest expense		1,346,667
	Discount on Bonds payable			13,334
	Cash			4,000,000
	(Record semi-annual bond interest payment and interest expense for two months)

Table (1)

Description:

December 31, 2015:

• Bond interest expense (decreases the equity) is increased. Thus, it is debited.
• Discount on bonds payable (contra liability account) is decreased. Thus, it is credited.
• Bond interest payable (liability) is increased. Thus, it is credited.

March 1, 2019:

• Bond interest payable (liability) is decreased. Thus, it is debited.
• Bond interest expense (decreases the equity) is increased. Thus, it is debited.
• Discount on bonds payable (contra liability account) is decreased. Thus, it is credited.
• Cash (asset) is decreased. Thus, it is credited.

Working note:

Calculate the bond interest payable as on December 31, 2015.

Bond Interest $\left(\$80,000,000\times 10\%\times \left[4÷1\text{2}\text{months}\right]\right)$	$2,666,667
Add: Discount amortization $\left(\$1,600,000\times \left[4÷240\text{months}\right]\right)$	26,667
Bond interest expense as on December 31, 2018	$2,693,334

Table (2)

Calculate the discount amortization for 2 months (January, February).

$\begin{array}{c}\text{Discount amortization}\text{=}\$\text{1,600,000}\times \left(2÷240\text{months}\right)\\ =\$13,334\end{array}$

2. The bonds were issued at 101. (Round to nearest dollar.)

Date	Account title and Explanation	Post Ref.	Debit ($)	Credit ($)
December 31, 2015	Bond Interest Expense		2,653,334
	Premium on Bonds Payable		13,333
	Bond Interest Payable			2,666,667
	(Record the adjusting entry for the year end December 31, 2015)
March 1, 2016	Bond Interest Payable		2,666,667
	Bond Interest expense		1,326,667
	Premium on Bonds payable		6,666
	Cash			4,000,000
	(Record semi-annual bond interest payment and interest expense for two months)

Table (3)

Description:

December 31, 2015:

• Bond interest expense (decreases the equity) is increased. Thus, it is debited.
• Premium on bonds payable (liability) is decreased. Thus, it is debited.
• Bond interest payable (liability) is increased. Thus, it is credited.

March 1, 2016:

• Bond interest payable (liability) is decreased. Thus, it is debited.
• Bond interest expense (decreases the equity) is increased. Thus, it is debited.
• Premium on bonds payable (liability) is decreased. Thus, it is debited.
• Cash (asset) is decreased. Thus, it is credited.

Working note:

Calculate the bond interest payable as on December 31, 2015.

Bond Interest $\left(\$80,000,000\times 10\%\times \left[4÷1\text{2}\text{months}\right]\right)$	$2,666,667
Less: Premium amortization $\left(\$800,000\times \left[4÷240\text{months}\right]\right)$	(13,333)
Bond interest expense as on December 31, 2018	$2,653,334

Table (4)

Calculate the premium amortization for 2 months (January, February).

$\begin{array}{c}\text{Premium amortization}\text{=}\$8\text{00,000}\times \left(2÷240\text{months}\right)\\ =\$6,666\end{array}$

b)

To determine

Compute the net bond liability at December 31, 2016, under assumptions 1 and 2.

Explanation of Solution

Compute the net bond liability at December 31, 2016, under assumptions 1 and 2:

	Bonds issued at $98	Bonds issued at $101
Bond payable	$80,000,000	$80,000,000
Less: Discount on bonds payable	(1,493,333)
Add: Premium on bonds payable		746,667
Net bond liability	$78,506,667	$80,746,667

Table (5)

Therefore, the net bond liability $98 is $78,506,667 and at $101 is $80,746,667.

Working notes:

Calculate the discount amortized on bonds payable as on December 31, 2016.

Total discount on bonds payable $(\text{\$80 million}\times \left(\$100-\$98\right) ÷\$100)$	$1,600,000
Amount amortized in 2015$\left(\$1,600,000\times \left[4÷240\text{months}\right]\right)$	$26,667
Amount amortized in 2016 $\left(\$1,600,000\times \left[12÷240\text{months}\right]\right)$	80,000
Discount amortized as on December 31, 2015	$106,667

Table (6)

Calculate the premium amortized on bonds payable as on December 31, 2016.

Total discount on bonds payable $(\text{\$80 million}\times \left(\$101-\$100\right) ÷\$100)$	$800,000
Premium amortized in 2015$\left(\$800,000\times \left[4÷240\text{months}\right]\right)$	$13,333
Premium amortized in 2016 $\left(\$800,000\times \left[12÷240\text{months}\right]\right)$	40,000
Discount amortized as on December 31, 2016	$53,333

Table (7)

c)

To determine

Find the assumption in part (a), in which the investor’s effective rate of interest is higher, explain the same.

Explanation of Solution

Under the assumption 1 of part (a), the effective rate of interest would be higher because the investors will pay less for bonds with a given rate of interest, the higher the effective interest rate the investors’ will earn.