Chapter 14, Problem 7P

1.

To determine

Prepare a bond interest expense and discount amortization schedule using the straight line method for Corporation W.

Explanation of Solution

Amortization Schedule: A schedule that gives the detail about each loan payment and shows the allocation of principal and interest over the life of the note, or bond is called amortization schedule.

Prepare a bond interest expense and discount amortization schedule using the straight line method for Corporation W.

CORPORATION W
DISCOUNT AMORTIZATION SCHEDULE - STRAIGHT LINE METHOD
Date	Cash (A = $1,000,000 × 6.75%)	Unamortized Discount (B = $14,928.32÷ 8)	Interest Expense (C = A +B)	Book value of bonds (D = Prior period D + B)
10/1/2016				$985,071.68
3/31/2017	$67,500	$1,866.04	$69,366.04	$986,937.72
9/30/2017	$67,500	$1,866.04	$69,366.04	$988,803.76
3/31/2018	$67,500	$1,866.04	$69,366.04	$990,669.80
9/30/2018	$67,500	$1,866.04	$69,366.04	$992,535.84
3/31/2019	$67,500	$1,866.04	$69,366.04	$994,401.88
9/30/2019	$67,500	$1,866.04	$69,366.04	$996,267.92
3/31/2020	$67,500	$1,866.04	$69,366.04	$998,133.96
9/30/2020	$67,500	$1,866.04	$69,366.04	$1,000,000.00

Table (1)

2.

To determine

Prepare a bond interest expense and discount amortization schedule using the effective interest method for Corporation W.

Explanation of Solution

Prepare a bond interest expense and discount amortization schedule using the effective interest method for Corporation W.

CORPORATION W
DISCOUNT AMORTIZATION SCHEDULE - EFFECTIVE INTEREST METHOD
Date	Cash (A = $1,000,000 × 6.75%)	Interest Expense ( B = Prior period D × 7%)	Unamortized Discount ( C = B – B)	Book value of bonds (D = Prior period D + C)
10/1/2016				$985,071.68
3/31/2017	$67,500	$68,955.02	$1,455.02	$986,526.70
9/30/2017	$67,500	$69,056.87	$1,556.87	$988,083.57
3/31/2018	$67,500	$69,165.85	$1,665.85	$989,749.42
9/30/2018	$67,500	$69,282.46	$1,782.46	$991,531.88
3/31/2019	$67,500	$69,407.23	$1,907.23	$993,439.11
9/30/2019	$67,500	$69,540.74	$2,040.74	$995,479.84
3/31/2020	$67,500	$69,683.59	$2,183.59	$997,663.44
9/30/2020	$67,500	$69,836.56	$2,336.56	$1,000,000.00

Table (2)

3.

To determine

Prepare adjusting entries for the end of fiscal year 31^st December 2016, using (a) straight line method of amortization, (b) effective interest method of amortization.

Explanation of Solution

a.

Prepare adjusting entries to record for the year end as on 31^st December 2016 using straight line method of amortization.

Date	Account titles and Explanation	Debit	Credit
December 31, 2016	Interest expense $\left(\frac{\$69,366.04}{2}\right)$	$34,683.02
	Discount on bonds payable $\left(\frac{\$1,866.04}{2}\right)$		$933.02
	Interest payable		$33,750
	(To record adjusting entry for accrued interest)

Table (3)

• Interest expense is a component of stockholders’ equity, and it is increases expense accounts. Therefore, debit interest expense account for $34,683.02.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $933.02.
• Interest payable is a current liability, and it is increased. Therefore, credit interest payable account for $33,750.

b.

Prepare adjusting entries to record for the year end as on 31^st December 2016 using effective interest method of amortization.

Date	Account titles and Explanation	Debit	Credit
December 31, 2016	Interest expense $\left(\frac{\$68,955.02}{2}\right)$	$34,477.51
	Discount on bonds payable $\left(\frac{\$1,455.02}{2}\right)$		$727.51
	Interest payable		$33,750
	(To record adjusting entry for accrued interest)

Table (4)

• Interest expense is a component of stockholders’ equity, and it is increases expense accounts. Therefore, debit interest expense account for $34,477.51.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $727.51.
• Interest payable is a current liability, and it is increased. Therefore, credit interest payable account for $33,750.

4.

To determine

Calculate net income under each method; assume income before interest and income taxes of 30% during 2017 is $500,000.

Explanation of Solution

Calculate net income under straight line method; assume income before interest and income taxes of 30% during 2017 is $500,000.

$\begin{array}{c}\text{Net income =}\left(\begin{array}{l}\text{Income before interest and}\\ \text{ income taxes }-\text{Interest expenses }\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(\$500,000-\left(\begin{array}{l}\frac{\$69,366.04}{2}+\$69,366.04\\ +\frac{\$69,366.04}{2}\end{array}\right)\right)\times \left(1-\text{Tax rate}\right)\\ =\left(\$500,000-\left(\begin{array}{l}\$34,683.02\\ +\$69,366.04+\$34,683.02\end{array}\right)\right)\times \left(1-30\%\right)\\ =\$252,888\end{array}$

Calculate net income under effective interest method; assume income before interest and income taxes of 30% during 2017 is $500,000.

$\begin{array}{c}\text{Net income =}\left(\begin{array}{l}\text{Income before interest and}\\ \text{ income taxes }-\text{Interest expenses }\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(\$500,000-\left(\begin{array}{l}\frac{\$68,955.02}{2}+\$69,056.87+\\ +\frac{\$69,165.85}{2}\end{array}\right)\right)\times \left(1-\text{Tax rate}\right)\\ =\left(\$500,000-\left(\begin{array}{l}\$34,477.51+\$69,056.87\\ +\$34,582.93\end{array}\right)\right)\times \left(1-30\%\right)\\ =\$253,318\end{array}$

5.

To determine

Prepare journal entry to record retirement of bonds as on 30^th June 2017, at 98 plus accrued interest using a. straight line method of amortization and b. effective interest method of amortization.

Explanation of Solution

a.

Prepare journal entry to record retirement of bonds as on 30^th June 2017, at 98 plus accrued interest using a. straight line method of amortization.

Date	Account titles and Explanation	Debit	Credit
June 30, 2017	Interest expense $\left(\frac{\$69,366.04}{2}\right)$	$34,683.02
	Discount on bonds payable $\left(\frac{\$1,455.02}{2}\right)$		$933.02
	Interest payable		$33,750
	(To record adjusting entry for accrued interest)
June 30, 2017	Bonds payable	$1,000,000
	Interest payable $\left(\frac{\$67,500}{2}\right)$	$33,750
	Discount on bonds payable $\left(\$13,062.28-\$933.02\right)$		$12,129.26
	Gain on bonds redemption		$7,870.74
	Cash $\left(\left[\$1,000,000\times 0.98\right]+\$33,750\right)$		$1,013,750.00
	(To record retirement of bonds)

Table (5)

Adjusting entry as on 30^th June 2017.

• Interest expense is a component of stockholders’ equity, and it is increases expense accounts. Therefore, debit interest expense account for $34,683.02.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $933.02.
• Interest payable is a current liability, and it is increased. Therefore, credit interest payable account for $33,750.

Retirement of bonds:

• Bonds payable is a liability, and it is increased. Therefore, debit bonds payable account for $1,000,000.
• Interest payable is a current liability, and it is decreased. Therefore, debit interest payable account for $33,750.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $12,129.26.
• Gain on bonds redemption is a component of stockholders’ equity, and it is increased. Therefore, credit gain on bonds redemption account for $7,870.74.
• Cash is a current asset, and it is decreased. Therefore, credit cash account for $1,013.750.

b.

Prepare journal entry to record retirement of bonds as on 30^th June 2017, at 98 plus accrued interest using effective interest method of amortization.

Date	Account titles and Explanation	Debit	Credit
June 30, 2017	Interest expense $\left(\frac{\$68,955.02}{2}\right)$	$34,477.51
	Discount on bonds payable $\left(\frac{\$1,455.02}{2}\right)$		$727.51
	Interest payable		$33,750
	(To record adjusting entry for accrued interest)
June 30, 2017	Bonds payable	$1,000,000
	Interest payable	$33,750
	Discount on bonds payable		$12,694.86
	Gain on bonds redemption		$7,305.14
	Cash		$1,013,750.00
	(To record retirement of bonds)

Table (6)

Adjusting entry as on 30^th June 2017.

• Interest expense is a component of stockholders’ equity, and it is increases expense accounts. Therefore, debit interest expense account for $34,477.0.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $727.51.
• Interest payable is a current liability, and it is increased. Therefore, credit interest payable account for $33,750.

Retirement of bonds:

• Bonds payable is a liability, and it is increased. Therefore, debit bonds payable account for $1,000,000.
• Interest payable is a current liability, and it is decreased. Therefore, debit interest payable account for $33,750.
• Discount on bonds payable is a contra liability, and it is decreased. Therefore, credit discount on bonds payable account for $12,694.86.
• Gain on bonds redemption is a component of stockholders’ equity, and it is increased. Therefore, credit gain on bonds redemption account for $7,305.14.
• Cash is a current asset, and it is decreased. Therefore, credit cash account for $1,013.750.

6.

To determine

Compute the time interest earned for 2017 under each alternative.

Explanation of Solution

Compute time interest earned for 2017 under straight line method.

$\begin{array}{c}\text{Interest earned}\text{ratio}\text{=}\frac{\text{Pretax operating income}}{\text{Interest expense}}\\ =\frac{\$500,000}{\$138,732.08}\\ =3.60\text{times}\end{array}$

Compute times interest earned for 2017 under effective interest method.

$\begin{array}{c}\text{Interest earned}\text{ratio}\text{=}\frac{\text{Pretax operating income}}{\text{Interest expense}}\\ =\frac{\$500,000}{\$138,117.31}\\ =3.62\text{times}\end{array}$