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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
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
Explanation of Solution
Explanation:
1. Computation of Premium on bonds payable
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 |
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:
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.
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