Chapter 14, Problem 10AP

1.

To determine

Prepare journal entry to record the issuance of bonds.

Explanation of Solution

Bonds: Bonds are long-term promissory notes that are issued by a company while borrowing money from investors to raise fund for financing the operations.

Journal:

Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system.

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

Date		Accounts and Explanations	Debit ($)	Credit ($)
2015
January	1	Cash	184,566
		Premium on Bonds Payable  (1)		4,566
		Bonds Payable		180,000
		(To record sale of bonds on states issue date)

Table (1)

• Cash is an asset account. The amount has increased because bonds are issued at a premium; therefore, debit Cash account with $184,566.
• Premium on Bonds Payable is an adjunct account to Bonds Payable account and it has a normal credit balance; therefore, credit Premium on Bonds Payable account with $4,566.
• Bonds Payable is a liability account and it is increased therefore; credit Bonds Payable account with $180,000.

Working note:

Calculate premium on bonds payable:

$\begin{array}{c}\text{Premium = Cash received–Issue}\text{price}\text{of}\text{bonds}\\ \text{=\$184,566 – \$180,000}\\ \text{=\$4,566}\end{array}$ (1)

2.

To determine

Ascertain the total bond interest expense recognized.

Explanation of Solution

Bond interest expense:

Bond interest expense is the interest charged by the bondholders at a certain rate of interest.

Particulars	Amount
Six payments of interest	$59,400
Par value at maturity	$180,000
Total repaid	$239,400
Less: amount borrowed	($184,566)
Total bond interest expense	$54,834

Table (2)

Note: Ten payments of interest=$59,400 $\left(\text{\$9,900×6 (3)}\right)$

Working note:

Calculate the semi-annual face interest rate:

$\begin{array}{c}\text{Semiannual face interest rate }=\frac{\text{Face interest rate}}{\text{2}}\\ =\frac{11\%}{2}\\ =5.5\%\end{array}$ (2)

Calculate amount of interest payable.

$\begin{array}{c}\text{Interest payable }=\text{Face value of bonds }\times \text{ Semiannual}\text{face interest rate}\\ =\$180,000\times \frac{5.5(2)}{100}\\ =\$9,900\end{array}$ (3)

Calculate the number of periods for semi-annual interest payment:

$\begin{array}{c}\begin{array}{l}\text{Number}\text{of}\text{periods}\\ \text{(for}\text{semi-annual)}\end{array}\}\text{=}\text{Number}\text{of}\text{years×2}\\ \text{=}3\text{×2}\\ \text{=6}\end{array}$ (4)

3.

To determine

Prepare an effective interest amortization table for the first two years of bonds.

Explanation of Solution

Amortization of bond:

The process of allocation and reduction of the discount or premium on bonds to interest expense over the life of bonds is referred to as amortization of bonds.

Table (3)

Note: 5.5 % is semi-annual face interest rate and 5 % is semi-annual market interest rate.

4.

To determine

Prepare the journal entries to record the first two interest payments

Explanation of Solution

Journal:

Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system.

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

Journalize the entry for the issue of bonds:

Date	Account Titles and Explanation	Debit ($)	Credit ($)
2015	Bond interest Expense [Refer to table(3) ]	9,228
June 30	Premium on Bonds payable [Refer to table(3) ]	672
	Cash (3)		9,900
	(To record six months’ interest and premium amortization.)

Table (4)

• Bond Interest Expense is a component of stockholders equity. There is an increase in the expense account which decreased the stockholders’ equity. Therefore, debit interest expense account by $9,228.
• Premium on Bonds payable is a contra liability account. The amount is decreased since the premium is amortized therefore; debit Premium on Bonds Payable account by $672.
• Cash is an asset and it is decreased. Therefore cash is credited by $9,900.

Date	Account Titles and Explanation	Debit ($)	Credit ($)
2015	Bond interest Expense  [Refer to table(3) ]	9,195
December 30	Premium on Bonds payable [Refer to table(3) ]	705
	Cash (3)		9,900
	(To record six months’ interest and premium amortization.)

Table (5)

• Bond Interest Expense is a component of stockholders equity. There is an increase in the expense account which decreased the stockholders’ equity. Therefore, debit interest expense account by $9,195.
• Premium on Bonds payable is a contra liability account. The amount is decreased since the premium is amortized therefore; debit Premium on Bonds Payable account by $705.
• Cash is an asset and it is decreased. Therefore cash is credited by $9,900.

5.

To determine

Prepare the journal entries to record retirement of bonds.

Explanation of Solution

Retirement of Bonds:

The process of repaying the sale amount of bonds to bondholders at the time of maturity or before the maturity period is called as redemption of bonds. It is otherwise called as redemption of bonds.

Date		Account Title and Explanation	Debit ($)	Credit ($)
2017		Bonds Payable	180,000
January 1		Premium on bonds payable [Refer to table(3) ]	1,670
		Cash (5)		176,400
		Gain on retirement of bonds (6)		5,270
		(To record the retirement of bonds)

Table (6)

• Bonds Payable is a liability account and it is decreased. Therefore, debit Bonds Payable account by $180,000.
• Premium on bonds payable is an adjunct-liability and it is decreased by $1,670. Therefore, debit premium on bonds payable account by $1,670.
• Cash is an asset account and it is decreased. Therefore credit cash account by $176,400.
• Gain on retirement of bonds is a component of stockholders’ equity and the amount is increased. Therefore credit gain on retirement of bonds by 5,270.

Working notes:

Calculate market price paid to retire the bonds.

$\begin{array}{c}\begin{array}{c}\text{Market price }\\ \text{paid to retire the bonds }\end{array}\}=\left(\begin{array}{l}\text{Face value × Market price}\\ \text{ paid to retire the bonds}\end{array}\right)\\ =\$180,000\times 0.98\\ =\$176,400\end{array}$ (5)

Calculate loss on retirement of bonds payable.

$\begin{array}{c}\begin{array}{l}\text{Gain on retirement }\\ \text{of bonds payable }\end{array}\}\text{=}\left(\begin{array}{l}\text{ Bonds payable + Premium on bonds payable}\\ \text{–}\text{Market price paid to retire the bonds}\end{array}\right)\\ =\$180,000+\$1,670-\$176,400\\ =\$5,270\end{array}$ (6)

6.

To determine

Describe the effect of change in market rate on the financial statements of Company I.

Explanation of Solution

Financial statements: Financial statements are condensed summary of transactions communicated in the form of reports for the purpose of decision making.

• The bonds would have sold at a discount if the market rate on the issue date has been 12 % instead of 10 % because the contract rate (11%) is lower than the market rate.
• This change affects the balance sheet as the bond liability would be smaller because the bond liability will increase with amortization of the discount instead of decreasing with amortization of the premium.
• The larger amount of interest expense is stated in the income statement over the life of the bonds issued at a discount than it would show if the bonds are issued at a premium.
• The cash received from borrowing is smaller in the statement of cash flows. But the cash flow prepared over the life of the bonds after its issuance reports the same amount of cash paid for interest.