Chapter 14, Problem 10BPSB

To determine

Issue of bond at premium:

When the coupon rate or contract rate of a bond is higher than the market interest rate, the bond is being issued at premium. If the bond is issued at premium, the selling price of the bond will be higher than the face value of the bond.

Effective interest method:

Effective interest method aims at computing an accurate interest expense. In case of issue of bonds on premium, the carrying value of the bonds payable inclusive of premium amortized is used to determine the interest expense during a particular period. Hence the interest expense decreases as the carrying value of the bonds decrease.

To determine:

1. Prepare journal entry for the issuance of bonds.

2. Compute the total bond interest expense to be recognized over the bonds’ life.

3. Preparation of amortization table for first two year using the effective interest method.

4. Prepare journal entry to record the first two interest payments.

5. Prepare journal entry to record the retirement of bonds on January 1, 2017, at 106.

6. If the market rate on January 1, 2015, is 14% instead of 10%. Without presenting numbers, describe how this change affects the amounts reported on Ike’s financial statement.

Answer to Problem 10BPSB

Solution:

1.

Date	Accounts	Debit	Credit
2015
Jan. 1	Cash	$493,608
	Bonds Payable		$450,000
	Premium on Bonds Payable		$43,608

2.
The total bond interest expense to be recognized over the bond’s life is $54,834.

3. Amortization Table

Period Ending	(A) Cash Interest Paid 6.5% X Par Value	(B) Bond Interest Expense 5% X Prior (E)	(C) Premium Amortization (A) − (B)	(D) Unamortized Premium Prior (D) − (C)	(E) Carrying Value Par Value + (D)
01/1/2015				$43,608	$493,608
06/30/2015	$29,250	$24,680	$4,570	$39,038	$489,038
12/31/2015	$29,250	$24,452	$4,798	$34,240	$484,240
06/30/2016	$29,250	$24,212	$5,038	$29,202	$479,202
12/31/2016	$29,250	$23,960	$5,290	$23,912	$473,912
06/30/2017	$29,250	$23,696	$5,554	$18,358	$468,358
12/31/2017	$29,250	$23,418	$5,832	$12,526	$462,526
06/30/2018	$29,250	$23,126	$6,124	$6,402	$456,402
12/31/2018	$29,250	$22,848	$6,402	0	$450,000
	$234,000	$190,392	$43,608

4. Journal entries to record the first two interest payments.

Date	General Journal	Debit	Credit
2015
Jun. 30	Interest Expense	$24,680
	Premium on Bonds Payable	$4,570
	Cash		$29,250
Dec. 31	Interest Expense	$24,452
	Premium on Bonds Payable	$4,798
	Cash		$29,250

5. Journal entry for the retirement of bonds payable

Date	General Journal	Debit	Credit
2017
Jan. 1	Bonds Payable	$450,000
	Premium on Bonds payable	$23,912
	Loss on retirement of bonds	$3,088
	Cash		$477,000

6.
If the market rate on January 1, 2015 is 14% instead of 10%, the issue will be on discount because the market rate exceeds the contract rate. As the interest expense is computed based on carrying value which includes the amortized discount, the interest expense will increase on the income statement and there will be contra liability account for the discount on the balance sheet.

Explanation of Solution

Explanation:

1. Computation of Premium on bonds payable

  $\begin{array}{l}\text{Premium }onBondsPayable=Issuepriceofthebond–Parvalueofthebond\hfill \\ =\$493,608-\$450,000\hfill \\ =\$43,608\hfill \end{array}$

2.

Computation of total interest expense

Amount to be repaid at maturity:

Total Interest Payment

$234,000

Par Value of Bonds

$450,000

Total amount to be repaid

$684,000

Less : Selling Price of the Bonds

$493,608

Total Bond Interest Expense

$190,392

  $\begin{array}{l}*InterestPayment=\$29,250X\text{ 8 }=\$234,000\hfill \\ *SemiannualInterestPayment=\$450,000X0.065=\$29,250\hfill \end{array}$

3.

4. The journal entry record the first two interest expense in effective interest method is basically same except the amount of interest expense and amortization per period changes.

5.

Par Value of the bonds (Dr.)	$450,000
Add: Unamortized Premium (12/31/2016)	$23,912
Carrying Value of bonds (12/31/2016)	$473,912
Less: Cash Proceeds on retirement ($450,000 X 1.06)	$477,000
Loss on retirement of bonds	$(3,088)

Conclusion

Conclusion:

It is concluded that the total interest expense over the life of the bonds is $190,392 and Valdez incurred a loss of $3,088 on retirement of the bonds.