Chapter 14, Problem 7P

Wilbury Corporation issued $1 million of 13.5% bonds for $985,071.68. The bonds are dated and issued October 1, 2019, are due September 30, 2020, and pay interest semiannually on March 31 and September 30. Assume an effective yield rate of 14%.

Required:

1. 1. Prepare a bond interest expense and discount amortization schedule using the straight-line method.
2. 2. Prepare a bond interest expense and discount amortization schedule using the effective interest method.
3. 3. Prepare adjusting entries for the end of the fiscal year December 31, 2019, using the:
   1. a. straight-line method of amortization
   2. b. effective interest method of amortization
4. 4. If income before interest and income taxes of 30% in 2020 is $500,000, compute net income under each alternative.
5. 5. Assume the company retired the bonds on June 30, 2020, at 98 plus accrued interest. Prepare the journal entries to record the bond retirement using the:
   1. a. straight line method of amortization
   2. b. effective interest method of amortization
6. 6. Compute the company’s times interest earned (pretax operating income divided by interest expense) for 2020 under each alternative.

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 $\left(A=\$1,000,000\times 6.75\%\right)$	Unamortized Discount $\left(B=\$14,928.32÷8\right)$	Interest Expense $\left(C=A+B\right)$	Book value of bonds $\left(D=\left(\begin{array}{l}PriorperiodD+\\ B\end{array}\right)\right)$
10/1/2019				$985,071.68
3/31/2020	$67,500	$1,866.04	$69,366.04	$986,937.72
9/30/2020	$67,500	$1,866.04	$69,366.04	$988,803.76
3/31/2021	$67,500	$1,866.04	$69,366.04	$990,669.80
9/30/2021	$67,500	$1,866.04	$69,366.04	$992,535.84
3/31/2022	$67,500	$1,866.04	$69,366.04	$994,401.88
9/30/2022	$67,500	$1,866.04	$69,366.04	$996,267.92
3/31/2023	$67,500	$1,866.04	$69,366.04	$998,133.96
9/30/2023	$67,500	$1,866.04	$69,366.04	$1,000,000.00

Table (1)

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 $\left(A=\$1,000,000\times 6.75\%\right)$	Interest Expense $\left(B=PriorperiodD\times 7\%\right)$	Unamortized Discount $\left(C=A–B\right)$	Book value of bonds $\left(\begin{array}{l}D=PriorperiodD+\\ C\end{array}\right)$
10/1/2019				$985,071.68
3/31/2020	$67,500	$68,955.02	$1,455.02	$986,526.70
9/30/2020	$67,500	$69,056.87	$1,556.87	$988,083.57
3/31/2021	$67,500	$69,165.85	$1,665.85	$989,749.42
9/30/2021	$67,500	$69,282.46	$1,782.46	$991,531.88
3/31/2022	$67,500	$69,407.23	$1,907.23	$993,439.11
9/30/2022	$67,500	$69,540.74	$2,040.74	$995,479.84
3/31/2023	$67,500	$69,683.59	$2,183.59	$997,663.44
9/30/2023	$67,500	$69,836.56	$2,336.56	$1,000,000.00

Table (2)

To determine

Prepare adjusting entries for the end of fiscal year 31^st December 2019, 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 2019 using straight line method of amortization.

Date	Account titles and Explanation	Debit	Credit
December 31, 2019	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 2019 using effective interest method of amortization.

Date	Account titles and Explanation	Debit	Credit
December 31, 2019	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.

To determine

Calculate net income under each method; assume income before interest and income taxes of 30% during 2020 is $500,000.

Explanation of Solution

Calculate net income under straight line method; assume income before interest and income taxes of 30% during 2020 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 2020 is $500,000.

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

To determine

Prepare journal entry to record retirement of bonds as on 30^th June 2020, 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 2020, at 98 plus accrued interest using a. straight line method of amortization.

Date	Account titles and Explanation	Debit	Credit
June 30, 2020	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, 2020	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 2020.

• 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 2020, at 98 plus accrued interest using effective interest method of amortization.

Date	Account titles and Explanation	Debit	Credit
June 30, 2020	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, 2020	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 2020.

• 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.

To determine

Compute the time interest earned for 2020 under each alternative.

Explanation of Solution

Compute time interest earned for 2020 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 2020 under effective interest method.

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