Chapter 14, Problem 14.5P

Issuer and investor; effective interest; amortization schedule; adjusting entries

• LO14–2

On February 1, 2018, Cromley Motor Products issued 9% bonds, dated February 1, with a face amount of $80 million. The bonds mature on January 31, 2022 (4 years). The market yield for bonds of similar risk and maturity was 10%. Interest is paid semiannually on July 31 and January 31. Barnwell Industries acquired $80,000 of the bonds as a long-term investment. The fiscal years of both firms end December 31.

Required:

1. Determine the price of the bonds issued on February 1, 2018.

2. Prepare amortization schedules that indicate (a) Cromley’s effective interest expense and (b) Barnwell’s effective interest revenue for each interest period during the term to maturity.

3. Prepare the journal entries to record (a) the issuance of the bonds by Cromley and (b) Barnwell’s investment on February 1, 2018.

4. Prepare the journal entries by both firms to record all subsequent events related to the bonds through January 31, 2020.

To determine

Bonds

Bonds are a kind of interest bearing notes payable, usually issued by companies, universities and governmental organizations. It is a debt instrument used for the purpose of raising fund of the corporations or governmental agencies. If selling price of the bond is equal to its face value, it is called as par on bond. If selling price of the bond is lesser than the face value, it is known as discount on bond. If selling price of the bond is greater than the face value, it is known as premium on bond.

Effective interest rate of amortization bond

Effective interest rate method of amortization is a process of amortizing premium on bond or discount on bond, which allocates the different amount of interest expense in each period of interest payment, but at a constant percentage rate.

Adjusting entries

Adjusting entries refers to the entries that are made at the end of an accounting period in accordance with revenue recognition principle, and expenses recognition principle.  The purpose of adjusting entries is to adjust the revenue, and the expenses during the period in which they actually occurs.

To Determine: The price value of the bonds as on 1st February 2018.

Explanation of Solution

Calculation of the price value of the bonds as on 1^st February 2018 as shown below:

$\begin{array}{c}\text{Price of the bonds =}\left(\begin{array}{l}\text{Present value of the principal +}\\ \text{ Present value of the interest payments}\end{array}\right)\\ \text{=}\$54,147,200+\$23,267,556\\ =\$77,414,756\end{array}$

Working notes:

Calculation of the present value of the principal amount as shown below:

Particulars	Amount ($)
Face value of bonds (a)	$80,000,000
PV factor at an annual market rate of 5% for 8 periods (b)	$\times$0.67684
Present value of face value of the bonds $\left(\text{a}\right)\text{×}\left(\text{b}\right)$	$54,147,200

Table (1)

Note: The present value of $1 for 8 periods at 5% is 0.67684 (refer Table 2 in Appendix).

Hence, present value of the principal amount is $54,147,200.

Calculation of the present value of the interest payment amount as shown below:

Particulars	Amount ($)
Interest payments amount (a)	$3,600,000
PV factor at an annual market rate of 5% for 8 periods (b)	$\times$6.46321
Present value of interest payments $\left(\text{a}\right)\text{×}\left(\text{b}\right)$	$23,267,556

Table (2)

Note: The Present value of an ordinary annuity of $1 for 8 periods at 5% is 6.87396 (refer Table 4 in Appendix).

Hence, the present value of interest payment amount is $23,267,556.

Calculation of the amount of interest payment as shown below:

$\begin{array}{c}\text{Interest payment}=\text{Face value of bonds}\times \text{ interest rate}\times \text{Time period}\\ =\$80,000,000\times \frac{9}{100}\times \frac{6}{12}\\ =\$3,600,000\end{array}$

Hence, the amount of interest payment is $3,600,000.

Therefore, price value of the bonds as on 30^th June 2020 is $77,414,756.

To determine

To Prepare: The amortization schedule for Products CM (issuer) and Industries B (Borrower).

Explanation of Solution

Calculation of the amortization schedule for Products CM (issuer) as shown below:

Figure (1)

Calculation of the amortization schedule for Industries B (Borrower) as shown below:

Figure (2)

To determine

To Prepare: The journal entry to record issuance of the bonds for products CM (Issuer) and Industries B (Borrower).

Explanation of Solution

Prepare the journal entry to record the issuance of the bonds for Products CM (Issuer) as on 1^st February 2018 as show below:

Date		Account Titles and Explanation	Debit ($)	Credit ($)
2018		Cash	77,414,756
February	1
		Discount on Bonds Payable	2,585,244
		Bonds Payable		80,000,000
		(To record the issue of bonds)

Table (3)

• Cash is a current asset, and increased. Therefore, debit cash account for $77,414,756.
• Discount on bonds payable is a contra liability, and decreased. Therefore, debit discount on bonds payable account for $2,585,244.
• Bonds payable is a long term liability, and increased. Therefore, credit bonds payable account for $80,000,000.

Prepare the journal entry to record the issuance of the bonds for Industries B (Borrower) as on 1^st February 2018 as show below:

Date		Account Title and Explanation	Debit ($)	Credit ($)
2018		Bonds Investment	80,000
February	1
		Discount on Bonds Investment		2,585
		Cash		77,415
		(To record the purchase of  bonds)

Table (4)

• Bond investment is a non- current asset, and increased. Therefore, debit investment on bonds account for $8,000.
• Discount on bonds payable is a contra liability, and increased. Therefore, credit discount on bonds payable account for $2,585.
• Cash is a current asset, and decreased. Therefore, credit cash account for $77,415.

To determine

To Prepare: The journal entry to record all the subsequent events related to the through 31^st January 2020 for both the firms.

Explanation of Solution

Prepare journal entry to record all subsequent events through January 31, 2018 for C (Issuer).

Journal entry to record interest on July 31, 2016 as show below:

Date		Account Title and Explanation			Debit ($)	Credit ($)
2018		Interest Expense			3,870,738
July	31		Discount on Bonds Payable			270,738
			Cash			3,600,000
				(To record payment of semi-annual interest)

Table (5)

Interest expense is a component of stockholders’ equity, and decreased it. Therefore, debit interest expenses account for $3,870,738.

Discount on bonds payable is a contra liability, and increased. Therefore, credit discount on bonds payable account for $270,738.

Cash is a current asset, and decreased. Therefore, credit cash account for $3,600,000.

Prepare the journal entry to record interest on December 31, 2018 as shown below:

Date		Account Title and Explanation			Debit ($)	Credit ($)
2018		Interest Expense			3,236,896
December	31		Discount on Bonds Payable			236,896
			Interest Payable			3,000,000
				(To record interest accrued)

Table (6)

Working notes:

Calculation of the amount of interest expense for 5 months a shown below:

$\begin{array}{c}\text{Interest expense for 5 months = \$3,884,275}\times \frac{5}{6}\\ =\$3,236,896\end{array}$

Hence, interest expenses amount is $3,236,896.

Calculation of the discount on bonds payable for 5 months a shown below:

$\begin{array}{c}\text{Discount on bonds payable for 5 months =\$284,275}\times \frac{5}{6}\\ =\$236,896\end{array}$

Hence, discount on bonds payable for 5 months amount is $236,896.

Calculation of the interest payable for 5 months as shown below:

$\begin{array}{c}\text{Interest payable for 5 months = \$3,600,000}\times \frac{5}{6}\\ =\$3,000,000\end{array}$

Hence, interest payable amount for 5 months is $3,000,000.

• Interest expense is a component of stockholders’ equity, and decreased it. Therefore, debit interest expenses account for $3,236,896.
• Discount on bonds payable is a contra liability, and increased. Therefore, credit discount on bonds payable account for $236,896.
• Interest payable is a current liability, and increased. Therefore, credit interest payable account for $3,000,000.

Prepare the journal entry to record interest on January 31, 2019 as shown below:

Date		Account Title and Explanation			Post Ref		Debit ($)	Credit ($)
2019		Interest Expense					647,379
January	31	Interest Payable					3,000,000
			Discount on Bonds Payable					47,379
			Cash					3,600,000
				(To record payment of interest)

Table (7)

Working notes:

Calculation of the amount of interest expense for 1 month as shown below:

$\begin{array}{c}\text{Interest expense for 1 month = \$3,884,275}\times \frac{1}{6}\\ =\$647,379\end{array}$

Hence, interest expenses amount for 1 month is $647,379.

Calculation of the discount on bonds payable for 1 month as shown below:

$\begin{array}{c}\text{Discount on bonds payable for 1 month =\$284,275}\times \frac{1}{6}\\ =\$47,379\end{array}$

Hence, discount on bonds payable for 1 month amount is $47,379.

• Interest expense is a component of stockholders’ equity, and decreased it. Therefore, debit interest expenses account for $647,379.
• Interest payable is a current liability, and decreased. Therefore, debit interest payable account for $3,000,000.
• Discount on bonds payable is a contra liability, and increased. Therefore, credit discount on bonds payable account for $47,379.
• Cash is a current asset, and decreased. Therefore, credit cash account for $3,600,000.

Prepare the journal entry to record interest on July 31, 2019 as shown below:

Date		Account Title and Explanation			Post Ref	Debit ($)	Credit ($)
2019		Interest Expense				3,898,488
July	31		Discount on Bonds Payable				298,488
			Cash				3,600,000
				(To record payment of semi-annual interest)

Table (8)

• Interest expense is a component of stockholders; equity, and decreased it. Therefore, debit interest expense account for $3,898,488.
• Discount on bonds payable is a contra liability, and increased. Therefore, credit discount on bonds payable account for $298,488.
• Cash is a current asset, and decreased. Therefore, credit cash account for $3,600,000.

Prepare the journal entry to record interest on December 31, 2019 as shown below:

Date		Account Title and Explanation			Post Ref		Debit ($)	Credit ($)
2019		Interest Expense					3,261,177
December	31		Discount on Bonds Payable					261,177
			Interest Payable					3,000,000
				(To record interest accrued)

Table (9)

Working notes:

Calculation of the amount of interest expense for 5 months as show below:

$\begin{array}{c}\text{Interest expense for 5 months = \$3,913,413}\times \frac{5}{6}\\ =\$3,261,177\end{array}$

Hence, interest expenses for 5 months amount is $3,261,177.

Calculation of the discount on bonds payable for 5 months as shown below:

$\begin{array}{c}\text{Discount on bonds payable for 5 months =\$313,413}\times \frac{5}{6}\\ =\$261,177\end{array}$

Hence, discount on bonds payable for 5 months amount is $261,177.

Calculation of the interest payable for 5 months as shown below:

$\begin{array}{c}\text{Interest payable for 5 months = \$3,600,000}\times \frac{5}{6}\\ =\$3,000,000\end{array}$

Hence, interest payable for 5 months amount is $3,000,000.

• Interest expense is a component of stockholders’ equity, and decreased it. Therefore, debit interest expenses account for $3,261,177
• Discount on bonds payable is a contra liability, and increased. Therefore, credit discount on bonds payable account for $261,177.
• Interest payable is a current liability, and increased. Therefore, credit interest payable account for $3,000,000.

Prepare the journal entry to record interest on January 31, 2020 as shown below:

Date		Account Title and Explanation			Post Ref		Debit ($)	Credit ($)
2020		Interest Expense (E–)					652,236
January	31	Interest Payable (L–)					3,000,000
			Discount on Bonds Payable (L+)					52,236
			Cash (A–)					3,600,000
				(To record payment of interest)

Table (10)

Working notes:

Calculation of the amount of interest expense for 1 month as shown below:

$\begin{array}{c}\text{Interest expense for 1 month = \$3,913,413}\times \frac{1}{6}\\ =\$652,236\end{array}$

Hence, interest expenses for 1 month amount is $652,236.

Calculation of the discount on bonds payable for 1 month as shown below:

$\begin{array}{c}\text{Discount on bonds payable for 1 month =\$313,413}\times \frac{1}{6}\\ =\$52,236\end{array}$

Hence, the discount on bonds payable amount for 1 month is $52,236.

• Interest expense is a component of stockholders’ equity, and decreased it. Therefore, debit interest expenses account for $652,236.
• Interest payable is a current liability, and decreased. Therefore, debit interest payable account for $3,000,000.
• Discount on bonds payable is a contra liability, and increased. Therefore, credit discount on bonds payable account for $52,236.
• Cash is a current asset, and decreased. Therefore, credit cash account for $3,600,000.

Prepare journal entry to record all subsequent events through January 31, 2018 for Industries B (Borrower).

Prepare the journal entry to record interest on July 31, 2018 as shown below:

Date		Account Title and Explanation			Post Ref	Debit ($)	Credit ($)
2018		Cash				3,600
July	31	Discount on Bonds Investment				271
			Interest Revenue				3,871
				(To record semi-annual interest revenue)

Table (11)

• Cash is a current asset, and increased. Therefore, debit cash account for $3,600.
• Discount on bonds investment is a contra asset, and decreased. Therefore, discount on bonds investment account for $271.
• Interest revenue is a component of stockholders’ equity, and increased it. Therefore, credit interest revenue account for $3,871.

Prepare the journal entry to record interest on December 31, 2018 as shown below:

Date		Account Title and Explanation			Post Ref	Debit ($)	Credit ($)
2018		Interest Receivable				3,000
December	31	Discount on Bonds Investment				237
			Interest Revenue				3,237
				(To record interest receivable)

Table (12)

Working notes:

Calculation of the interest receivable for 5 months as shown below:

$\begin{array}{c}\text{Interest receivable for 5 months = \$3,600}\times \frac{5}{6}\\ =\$3,000\end{array}$

Hence, interest receivable for 5 months amount is $3,000.

Calculation of the discount on bonds payable for 5 months as shown below:

$\begin{array}{c}\text{Discount on bonds payable for 5 months =\$284}\times \frac{5}{6}\\ =\$237\end{array}$

Hence, discount on bonds payable amount is $237.

Calculation of the interest revenue for 5 months as shown below:

$\begin{array}{c}\text{Interest revenue for 5 months = \$3,884}\times \frac{5}{6}\\ =\$3,237\end{array}$

Hence, interest revenue account is $3,237.

• Interest receivable is a current asset, and increased. Therefore, debit interest receivable account for $3,000.
• Discount on Bond investment is a contra asset, and decreased. Therefore, discount on bond investment account is $237.
• Interest revenue is a component of stockholders’ equity, and increased it. Therefore, credit interest revenue account for $3,237.

Prepare the journal entry to record interest on January 31, 2019 as shown below:

Date		Account Title and Explanation			Post Ref	Debit ($)	Credit ($)
2019		Cash				3,600
January	31	Discount on Bonds Investment				47
			Interest Receivable				3,000
			Interest Revenue				647
				(To record interest revenue)

Table (13)

Working notes:

Calculation of the discount on bonds payable for 1 month as shown below:

$\begin{array}{c}\text{Discount on bonds payable for 1 month =\$284}\times \frac{1}{6}\\ =\$47\end{array}$

Hence, discount on bonds payable amount is $47.

Calculation of the interest revenue for 1 month as shown below:

$\begin{array}{c}\text{Interest revenue for 1 month = \$3,884}\times \frac{1}{6}\\ =\$647\end{array}$

Hence, interest revenue amount is $647.

• Cash is a current asset, and increased, therefore, debit cash account for $3,600.
• Discount on bonds investment is a contra asset, and decreased. Therefore, debit discount on bonds investment account for $47.
• Interest receivable is a current asset, and decreased. Therefore, debit interest receivable account for $3,000.
• Interest revenue is a component of stockholders’ equity, and increased it. Therefore, credit interest revenue account for $647.

Prepare the journal entry to record interest on July 31, 2019as shown below:

Date		Account Title and Explanation			Post Ref	Debit ($)	Credit ($)
2019		Cash				3,600
July	31	Discount on Bonds Investment				299
			Interest Revenue				3,899
				(To record semi-annual interest revenue)

Table (14)

• Cash is a current asset, and increased. Therefore, debit cash account for $3,600.
• Discount on bonds investment is a contra asset, and decreased. Therefore, discount on bonds investment account for $299.
• Interest revenue is a component of stockholders’ equity, and increased it. Therefore, credit interest revenue account for $3,899.

Prepare the journal entry to record interest on December 31, 2017:

Date		Account Title and Explanation			Post Ref	Debit ($)	Credit ($)
2017		Interest Receivable				3,000
December	31	Discount on Bonds Investment				261
			Interest Revenue				3,261
				(To record interest receivable)

Table (15)

Working notes:

Calculation of the interest receivable for 5 months as shown below:

$\begin{array}{c}\text{Interest receivable for 5 months = \$3,600}\times \frac{5}{6}\\ =\$3,000\end{array}$

Hence, interest receivable amount for $3,000.

Calculation of the discount on bonds payable for 5 months as shown below:

$\begin{array}{c}\text{Discount on bonds payable for 5 months =\$313}\times \frac{5}{6}\\ =\$261\end{array}$

Hence, discount on bonds payable amount is $261.

Calculation of the interest revenue for 5 months as shown below:

$\begin{array}{c}\text{Interest revenue for 5 months = \$3,913}\times \frac{5}{6}\\ =\$3,261\end{array}$

Hence, interest revenue amount is $3,261.

• Interest receivable is a current asset, and increased. Therefore, debit interest receivable account for $3,000.
• Discount on Bond investment is a contra asset, and decreased. Therefore, discount on bond investment account is $261.
• Interest revenue is a component of stockholders’ equity, and increased it. Therefore, credit interest revenue account for $3,261.

Prepare the journal entry to record interest on January 31, 2020 as shown below:

Date		Account Title and Explanation			Post Ref	Debit ($)	Credit ($)
2020		Cash (A+)				3,600
January	31	Discount on Bonds Investment (L–)				52
			Interest Receivable (A–)				3,000
			Interest Revenue (E–)				652
				(To record interest revenue)

Table (16)

Working notes:

Calculation of the discount on bonds payable for 1 month as shown below:

$\begin{array}{c}\text{Discount on bonds payable for 1 month =\$313}\times \frac{1}{6}\\ =\$52\end{array}$

Hence, discount on bonds payable amount is $52.

Calculation of the interest revenue for 1 month as shown below:

$\begin{array}{c}\text{Interest revenue for 1 month = \$3,913}\times \frac{1}{6}\\ =\$652\end{array}$

Hence, interest revenue amount is $652.

• Cash is a current asset, and increased, therefore, debit cash account for $3,600.
• Discount on bonds investment is a contra asset, and decreased. Therefore, debit discount on bonds investment account for $52.
• Interest receivable is a current asset, and decreased. Therefore, debit interest receivable account for $3,000.
• Interest revenue is a component of stockholders’ equity, and increased it. Therefore, credit interest revenue account for $652.