Module 13 Liabilities Types of Bonds A bond payable is a long-term promissory note. It has this information: issue date, maturity date, par value, stated interest rate, and a schedule of interest payments. Par value (known also as face value or maturity value) of the bond is the amount that the bond issuer pays to the bondholder at maturity. The bond indenture specifies the details of the agreement between a company and the bondholders. It may include restrictive covenants that specify limitations on the company’s activities (such as restricting the amount of dividends or additional borrowing) and financial condition (such as specifying the maintenance of minimum working capital or liquidity ratios). Term bonds mature (that is, become due) on a single date. Serial bonds mature in installments (at different dates). Mortgage bonds are backed by specific assets of the borrower as collateral. Debentures are unsecured bonds without any specific collateral. Convertible bonds can be converted at a future date to common stock or some other equity. Callable bonds give the issuing company the right to call (that is, buy back from the bondholder) the bonds and retire them prior to the maturity date. High-yield bonds have a high interest rate. Such bonds (often referred to as junk bonds ) are usually issued by growing companies without a long history of profitable operations and therefore have a higher likelihood of default. Interest Rates and Bonds A bond’s stated rate (also called the coupon rate ) is the rate of interest the issuer of the bond pays. The stated rate may depend on a variety of factors, such as the prevailing market condition and risk factors associated with the company. In general, the higher the risk
Transcript
Module 13Liabilities
Types of Bonds
A bond payable is a long-term promissory note. It has this information: issue date, maturity date, par value, stated interest rate, and a schedule of interest payments. Par value (known also as face value or maturity value) of the bond is the amount that the bond issuer pays to the bondholder at maturity.
The bond indenture specifies the details of the agreement between a company and the bondholders. It may include restrictive covenants that specify limitations on the company’s activities (such as restricting the amount of dividends or additional borrowing) and financial condition (such as specifying the maintenance of minimum working capital or liquidity ratios).
Term bonds mature (that is, become due) on a single date. Serial bonds mature in installments (at different dates).
Mortgage bonds are backed by specific assets of the borrower as collateral. Debentures are unsecured bonds without any specific collateral. Convertible bonds can be converted at a future date to common stock or some other equity. Callable bonds give the issuing company the right to call (that is, buy back from the bondholder) the bonds and retire them prior to the maturity date.
High-yield bonds have a high interest rate. Such bonds (often referred to as junk bonds) are usually issued by growing companies without a long history of profitable operations and therefore have a higher likelihood of default.
Interest Rates and Bonds
A bond’s stated rate (also called the coupon rate) is the rate of interest the issuer of the bond pays. The stated rate may depend on a variety of factors, such as the prevailing market condition and risk factors associated with the company. In general, the higher the risk of default associated with a company’s bonds, higher is the stated rate of interest. The stated rate need not be the same as the rate of interest paid by other bonds of similar risk and similar maturity.
The buyer of a bond has many alternatives from which to choose. For a particular company’s bond to be attractive to the buyer, its coupon rate must at least equal the rate available from the other alternatives available in the market at that time. This rate, which is available to bond buyers from other options, is the market rate of interest. The market rate, also known as the effective interest rate or yield, is the annual rate of interest that the company issuing the bond must offer. The market rate for bonds can vary over time.
Bond Discount and Premium
As noted, because of market fluctuations, a bond’s stated rate of need not exactly equal the market rate. In such instances, the bond is offered at a discount or premium.
If the stated rate exactly equals the market rate, the bond is sold at par, that is, the price the buyer pays exactly equals the face value of the bond.
If the stated rate is less than the prevailing market rate, the company’s bond is less attractive to the prospective bond buyer than other bonds available in the market. (This occurs because other bonds pay higher market rates of interest.) If your product is less attractive than other alternatives available in the market, you cut the price, or sell your product at a discount. Thus, when the stated rate is less than the market rate, bonds are sold at a discount. The bond buyer will purchase the bonds only for an amount less than the face value when the company sells them.
In contrast, if the stated rate is higher than the prevailing market rate, the company’s bond is more attractive than other bonds available in the market to the prospective bond buyer. Therefore, sell your bond at a premium. This means the bond buyer will pay an amount higher than the face value when the company sells the bonds.
Bond prices are usually quoted as percent of the face value. Thus, a bond sold for 102 was sold for 102% of par value, or at a 2% premium over par value. A bond sold for 97 was sold for 97% of par value, or at a 3% discount relative to par value.
Bonds Issued at Par
The buyer of a bond expects to receive two things: Interest each period (that is, an annuity) The face value of the bond (a single-sum payment) on the maturity date. The price that the bond buyer is willing to pay exactly equals the present value of these two items.
Note the following: Cash paid as interest each period equals face value of the bond times the stated interest
rate (if the interest is paid annually; otherwise, appropriate adjustment for time period must be made).
However, for present value discounting purposes, the relevant rate is the market rate of interest.
The first interest payment usually occurs at the end of the first period. Thus, the interest payments constitute an ordinary annuity.
ExampleGibbs Company issued bonds with a face value of $10,000. The stated rate, which also equals the market rate (in this example), is 10% and the bonds mature in 10 years. What price will a buyer pay for the bonds, which pay interest annually?
The annual interest payment = $10,000 x 0.10 = $1,000.The buyer gets two things:1. An annuity of interest payments, for 10 years, of $1,000 each year.2. $10,000 once, at the end of 10 years.
Present value of the interest annuity = $1,000 times present value of an ordinary annuity factor for 10 years at 10% = $1,000 x 6.1446 = $6,144.60
Present value of the face value = $10,000 times the present value of a single sum discounted for 10 years at 10% = $10,000 x 0.3855 = $3,855.00Total present value = $6,144.60 + $3,855.00 = $10,000 (rounded).
(Note: 1. The difference of 0.40 arises because of rounding errors in the present value numbers used.2. Because this is an example and to ensure clear understanding, we have used more exact numbers in the tutorials only for present values than given in the tables at the end of this module.)
The present value of what you get equals the present value of what you pay. Hence, the bond buyer will be willing to pay $10,000 for the bond. Note that this is what you would expect, given that the stated rate equals the market rate in this example. Hence, the bond should sell for par, which is $10,000.
Bonds Issued at a Discount
In the preceding example, what price will the bond buyer pay if the market interest rate were 12% as opposed to 10%?
Remember that the stated rate is 10%.If the market rate is 12%, the bond must sell for a discount (because the stated rate is less than the market rate). The actual discount amount and the bond price can be calculated as follows:
The bond buyer still expects to get the same two things: an interest annuity of $1,000 per year (remember that the cash interest paid depends on the coupon rate, not the market rate) for 10 years and a single sum of $10,000 at the end of 10 years. Now, however, the discount rate used by the bond buyer is 12%, which is the market rate.
Present value of the interest annuity = $1,000 multiplied by present value of an ordinary annuity factor, for 10 years at 12% = $1,000 x 5.6502 = $5,650.20.Present value of the face value = $10,000 times the present value of a single sum, discounted for 10 years at 10% = $10,000 x 0.3220 = $3,220.00.Total present value = $5,650.20 + $3,220.00 = $8,870.20.
Thus, the bond will sell for $8,870.20. The difference between the face value and the selling price, $1,129.80 ($10,000 – $8,870.20), is the bond discount.
Bonds Issued at a Premium
Continuing with the Gibbs Company example, what price would the bond buyer pay if the market interest rate were 8% as opposed to 10%?
Remember that the stated rate is 10%.If the market rate is 8%, the bond must sell for a premium (because the stated rate is higher than the market rate). The actual premium amount and the bond price can be calculated as follows.
The bond buyer still expects to get the same two things: an interest annuity of $1,000 per year (remember that the cash interest paid depends on the coupon rate, not the market rate) for 10 years and a single sum of $10,000 at the end of 10 years. Now, however, the discount rate used by the bond buyer is 8%, which is the market rate.
Present value of the interest annuity = $1,000 times present value of an ordinary annuity factor for 10 years at 8% = $1,000 x 6.7101 = $6,710.10.Present value of the face value = $10,000 times the present value of a single sum discounted for 10 years at 8% = $10,000 x 0.4632 = $4,632.00.Total present value = $6,710.10 + $4,632.00 = $11,342.10.
Thus, the bond will sell for $11,342.10. The difference between the face value and the sellingprice, $1,342.10 ($11,342.10 – $10,000), is the bond premium.
Journal Entries at the Time Bonds Are Issued
When bonds are issued, the journal entry is straightforward. The cash account is debited for the amount of cash collected, and the Bonds Payable account is credited for the face value of the bonds. The face value of the bonds equals the value of the Bonds Payable account shown on the balance sheet.
Note that if bonds are issued at a discount, cash collected when the bonds are issued is less than face value. Hence, to make debits equal credits, we need an additional entry on the debit side. The “plug” number is a debit for Discount on Bonds Payable. This is a contra-liability account and is deducted from Bonds Payable on the balance sheet. Thus, the net amount of Bonds Payable on the balance sheet (Bonds Payable less Discount on Bonds Payable) will be less than the face value of bonds.
If bonds are issued at a premium, cash collected when the bonds are issued is more than the face value. Hence, to make debits equal credits, we need an additional entry on the credit side. The “plug” number is a credit to the Premium on Bonds Payable account. The Premium on Bonds Payable is added to Bonds Payable on the balance sheet. Thus, the net amount of Bonds Payable on the balance sheet (Bonds Payable plus Premium on Bonds Payable) will be more than the face value of bonds.
Interest Expense (Effective Interest Method)
Assume that a company issues10% bonds with a face value of $10,000 on January 1, 2002, with interest payable on December 31 of each year.
If the bonds were issued at par, the journal entry for interest is straightforward. The cash interest paid is $1,000 (10% of $10,000). The journal entry is
Debit Interest Expense $1,000Credit Cash $1,000
If the bonds are issued at a premium or discount, the calculation of interest expense (and, hence, the journal entry is more complicated). Performing the following steps is useful in such an exercise.
Step 1Cash interest paid = (Face value of bonds) x (Stated interest rate).(Note: If the interest is stated in terms of “% per annum” and is paid in periods other than annually (such as semiannually or quarterly), the stated rate must be adjusted appropriately. For instance, if the stated rate is 10% per annum, and interest is paid semiannually, the appropriate rate is 5% per period.)
Step 2Interest expense = (Beginning balance of the net Bonds Payable account) x (Effective interest rate)
Notes:a. Effective interest rate = Market rate at the time of issuance of the bond.
b. If bonds are issued at a premium:Beginning balance of net Bonds Payable = Face value of Bonds Payable + Premium on Bonds Payable
c. If bonds are issued at a discount:Beginning balance of net Bonds Payable = Face value of Bonds Payable – Discount on Bonds Payable
d. Note the difference between steps 1 and 2: Stated rate is used for cash interest paid, and effective interest rate is used for interest
expense. If you have discount or premium, the two rates will be different. Face value of bonds is used for the cash interest paid calculation; the beginning balance of
net Bonds Payable is used for interest expense calculation. If you have a discount or premium, the beginning balance in Bonds Payable will not equal the bond’s face value.
Step 3The difference between the cash interest paid and interest expense (the “plug” number) equals the amortization of the Discount on Bonds Payable, or Premium on Bonds Payable (depending on whether the bonds were issued at a discount or premium, respectively).
Interest Expense–Bonds Issued at Discount
The interest expense and discount or premium amortization each period can be calculated using amortization tables as follows.
Assume that 10%, 10-year bonds with a face value of $10,000 were issued on January 1, 2002, when the market rate is 12%. The bonds will sell (as shown previously) for a discount, and the selling price will be $8,870 (rounded). (Present value of the interest annuity = $1,000 x 5.650 = $5,650.Present value of the face value = $10,000 x 0.3220 = $3,220.Total present value = $5,650 + $3,220 = $8,870).
Set up a table with seven columns as follows. The term “book value” refers to the net book value of Bonds Payable, that is, the face value of the bonds plus any premium or minus any
discount, as is the case. Thus, on January 1, 2002, when the bonds are issued, the book value of Bonds Payable account is $8,870.
Notes:a. In the last period, the amounts may not tally exactly because of rounding in all the previous periods. Hence, in the last period alone, work as follows: First, bring the discount balance to zero, so that amount will be the discount amortized. Second, cash interest paid will stay the same as in previous periods. This, in turn, gives the interest expense as the “plug” number.
b. When bonds are issued at a discount, cash paid each period is less than the interest expense for each period. Thus, to make debits equal credits, an extra “plug” entry on the credit side is required. This is the credit entry to the Amortization of Discount Bonds Payable account.
c. You need not memorize this information, but you can logically determine the steps. Remember that Discount on Bonds Payable is a contra-liability account. So, if Bonds Payable must have a credit balance, the normal balance for Discount on Bonds Payable must be a debit. Hence, amortization of Discount on Bonds Payable (which reduces the balance in this account)
must require a credit entry. (This also means that the cash paid must be less than the interest expense to make debits equal credits in the journal entry to record interest expense.)
d. Note that interest expense increases each period when bonds are issued at a discount. The discount amortized also increases over time.
Interest Expense–Bonds Issued at Premium
Assume that 10%, 10-year bonds with a face value of $10,000 were issued on January 1, 2002, when the market rate is 8%. The bonds will sell (as shown previously) for a premium, and the selling price will be $11,342 (rounded).
(Present value of the interest annuity = $1,000 x 6.710 = $6,710.Present value of the face value = $10,000 x 0.4632 = $4,632.Total present value = $6,710 + $4,632 = $11,342).
Set up a table with seven columns as follows. The term “book value” refers to the net book value of Bonds Payable–that is, the face value of the bonds plus any premium or minus any discount, as is the case. Thus, on January 1, 2002, when the bonds are issued, the book value of Bonds Payable is $8,870.
Step 5Thus, the new ending balance of the Bonds Payable account = $10,000 + $1,249 = $11,249.(Alternatively, ending book value of Bonds Payable = $11,342 – $93 = $11,249.)
This, in turn, becomes the beginning book value for the next period, as shown here.
Notes:a. In the last period, the amounts may not tally exactly because of rounding in all the previous periods. Hence, for only the last period, work as follows: First, bring the premium balance to zero, which will be the premium amortized. Second, cash interest paid will stay the same as in previous periods. This in turn gives the interest expense as the “plug” number.
b. When bonds are issued at a premium, cash paid each period is more than the interest expense for each period. Thus, to make debits equal credits, an extra “plug” entry on the debit side is required. This is the debit entry to the Amortization of Premium on Bonds Payable account.
c. You need not memorize this information, but you can logically determine the steps. The Premium on Bonds Payable account adds to the Bonds Payable account, so the normal balance for Premium on Bonds Payable must be a credit. Hence, amortization of Premium on Bonds Payable (which reduces the balance in this account) must require a debit entry. (This also means that the cash paid must be more than the interest expense to make debits equal credits in the journal entry to record interest expense.)
d. Note that interest expense decreases each period when bonds are issued at a premium. The premium amortized, however, increases over time.
Extinguishment (Retirement) of Bonds
Bonds may be retired (“extinguished”) either at or before maturity. When bonds are retired at maturity, the accounting is simple. The journal entry is as follows:
Debit Bonds PayableCredit Cash
Bonds may also be retired before the maturity date. This may be done in any of the following ways: Open-market purchases. Exercise of the call provision. Conversions (to other securities, such as common stock).
When bonds are purchased in the open market and retired, the journal entries are as follows.
Step 1Credit the Cash account for the price paid to acquire the bonds.
Step 2Debit the Bonds Payable account for the face value of the bonds.
Step 3
Because the bonds have been removed, any associated discount or premium also must be removed. Hence, debit Premium on Bonds Payable if the account has a balance or credit Discount on Bonds Payable if the account has a balance.
Step 4Debits must equal credits, so if there is a difference, the balance is a gain or loss. If the total of debits in steps 1–3 is more than the total of credits in steps 1–3, we need a “plug” entry on the credit side; this is the gain from extinguishment of debt. Conversely, if the total of debits in steps 1–3 is less than the total of credits in steps 1–3, we need a “plug” entry on the debit side; this is the loss from extinguishment of debt. Note that such gain or loss is always classified as an extraordinary item in the income statement.
When a company exercises the call option to buy back and retire the bonds, the journal entries are similar to the ones in the preceding four steps.
Note that these journal entries assume the purchase of bonds immediately after interest has been paid. Often a company purchases the bonds at a date other than the interest payment date. In such instances, the company must pay the interest (and record the reduction of discount or premium and the interest expense) for the time from the previous interest payment date to the date of the purchase of the bonds.
Troubled-Debt: Asset Transfer
Sometimes companies that have issued bonds (or other obligations such as notes payable) cannot make the required payments (such as the periodic interest or redemption at maturity). In such instances, the creditors may decide to change the terms of the bond. This is called troubled-debt restructuring. Sometimes the restructuring involves transfers of assets to settle the obligation. Consider the following example.
Henry Company had $100,000 face value bonds outstanding. The unamortized discount on the bonds was $3,000, and the company did not make the last interest payment due of $5,000. The company’s creditors agreed to settle the debt in exchange for a transfer of land with a market value of $90,000. The original cost of the land on the books of Henry Company is $70,000. The process for accounting for this transaction by Henry Company is as follows.
Steps 1 & 2Because the bonds have been settled, the Bond Payable account must be debited, and the corresponding Discount on Bonds Payable account must be credited.
Step 3Because the interest is no longer due, the Interest Payable account must be debited.
Step 4Because land has been given up, the Land account must be credited for the book value.
Steps 5 & 6Land with a book value of $70,000 and a market value of $90,000 was exchanged. Thus, a gain of $20,000 related to land has occurred, and this is reported as a gain on disposal.
Thus, the company was able to reduce $102,000 of obligations ($100,000 – $3,000 + $5,000) by giving up only $90,000 worth of assets. This results in a gain of $12,000 on extinguishment of debt. This amount must be reported as an extraordinary gain.
Debit CreditBonds Payable (step 1) $ 100,000Interest Payable (step 3) 5,000 Discount on Bonds Payable (step 2) 3,000 Land (step 4) 70,000 Gain on Disposal of Land (step 5) 20,000 Extraordinary Gain on Extinguishment of Debt (step 6)
Troubled-Debt: Modification of Terms
The creditors also may decide to modify the terms of debt if the borrower is in financial trouble. Such a change could involve any one or more of the following: rate of interest, maturity date, and maturity amount.
In such instances, the accounting by the troubled company depends on one question: Do the total payments due after the modification (but without any present value discounting) at least equal the total amount due now? If so, then the troubled company does not record a gain at the time of the restructuring. The new interest is the implicit rate that makes the present value of the future payments equal the amount due now. Because the new rate is usually lower than the old interest rate, the periodic interest expense in the future also is lower than before the restructuring.
If the answer to the question is no, the difference between the two amounts compared is immediately recorded as a gain. Note that this also means that, after the gain has been recorded, the total payments due without regard to present values equal the amount due now. This, in turn, means the company will have no interest expense in the future; that is, in essence, the loan has become a zero-interest loan.
The journal entries at the time of the restructuring are as follows. First, remove the old debt and any associated discount or premium. Second, remove any interest payable that has not been paid. Third, record the new, restructured debt. Fourth, record the gain (if any).
Glossary
Bond indenture specifies the details of the agreement between a company and bondholders.
Bond payable is a long-term promissory note.
Callable bonds give the issuing company the right to call (that is, buy back from the bondholder) the bonds and retire them prior to the maturity date.
Convertible bonds can be converted to common stock or some other equity at a future date.
Debentures are unsecured bonds without any specific collateral.
Discount on bonds arises when the stated rate is lower than the market rate. In this situation, the bond buyer pays an amount lower than the face value when the company sells the bonds.
Face value (known also as par value or maturity value) of the bond is the amount that the bond issuer pays to the bondholder at maturity.
Junk bonds have high interest rates and are usually issued by growing companies without a long history of profitable operations.
Mortgage bonds are backed by specific assets of the borrower as collateral.
Par is the term used when the stated rate of a bond equals the market rate. In this situation, the price the buyer pays exactly equals the bond’s face value.
Par value (known also as face value or maturity value) of the bond is the amount that the bond issuer pays to the bond issuer to the bondholder at maturity.
Premium arises when the stated rate is higher than the market rate for a bond. In this situation, the bond buyer pays an amount higher than the face value when the company sells the bonds.
Serial bonds mature (that is, become due) in installments (at different dates).
Term bonds mature (that is, become due) on a single date.
Demonstration Problem 1Cheney Company
Cheney Company issued 8%, 9-year bonds with a face value of $20,000 on January 1, 2002. The effective interest rate on the bonds was 10%, and the interest is payable on December 31 each year. Prepare the following:(a) Journal entries at the time bonds were issued.(b) Amortization schedule showing the interest expense for the first three years.(c) Journal entries for interest expense for the first two years.Use the time value of money tables given in this module.
Solution to Demonstration Problem 1, Cheney Company
a. Journal entry for issuance of the bondsInterest annuity = $1,600 per year ($20,000 x .08)Present value of the interest annuity = $1,600 x 5.75 = $9,200Present value of the face value = $20,000 x 0.42 = $8,400Total present value = $9,200 + $8,400 = $17,600Hence, the journal entry is:
(c) Journal entries for interest expenseAt the end of the first year:Date Account Debit Credit12/31/02 Interest Expense 1,760
Cash 1,600 Discount on Bonds Payable 160
At the end of the second year:Date Account Debit Credit12/31/03 Interest Expense 1,776
Cash 1,600 Discount on Bonds Payable 176
Demonstration Problem 2Lieberman Company
Lieberman Company issued bonds with a face value of $50,000 on January 1, 2002, at 97. On January 1, 2005, the company bought back the bonds for $52,000 through open market purchases. The balance of discount on the bonds was $1,000, at the time of the purchase. Prepare the journal entries to record (a) Issuance of the bonds on January 1, 2002(b) Purchase and retirement of bonds on January 1, 2005.
Solution to Demonstration Problem 2, Lieberman Company
a. Bonds were issued “at 97”, meaning the bonds were sold for 97% of the face value.Thus, the selling price of bonds = $50,000 x 0.97 = $48,500.Journal entry to record the sale of bonds
b. Journal entry to record the purchase and retirement of bondsDebit Credit
Bonds Payable (step 2) 50,000Loss on Extinguishment of Debt (step 4) 3,000 Cash (step 1) 52,000 Discount on Bonds Payable (step 3) 1,000
Demonstration Problem 3Miller Company
Miller Company had issued 7-year, 10% bonds with a face value of $100,000 on January 1, 2002, at 99. By 2004, the company had run into financial difficulties and did not pay $3,500 of the interest payment due on December 31, 2004. On January 1, 2005, when the unamortized discount on bonds payable was $650, the bonds were restructured as follows: the company would pay interest of $6,500 per year, and the maturity date would be extended to six years from January 1, 2005 (the maturity value would remain the same $100,000). Prepare the journal entries to record the restructuring and the interest payment on December 31, 2005.
Solution to Demonstration Problem 3, Miller Company
Step 1Total payments after restructuring = ($6,500 x 6) + $100,000.Since this is more than the carrying value of the bonds, no gain occurs at the time of the restructuring.
Journal entry at the time of the restructuringDebit Credit
Step 2Calculate the implicit interest rate.$102,850 = Present value of a single sum of $100,000, six years from now + Present value of interest annuity of $6,500 for six years.By trial and error, we find the interest rate to be 6% per year[($100,000 x 0.71) + (6,500 x 4.90) = $102,850].
Step 3Interest expense journal entries on December 31, 2005.Interest expense for the year = $102,850 x 0.06 = $ 6,171.
Agnew Company issued 12%, 8-year bonds with a face value of $50,000 on January 1, 2002. The effective interest rate on the bonds was 10%, and the interest is payable on December 31 each year. Prepare the following:a. Journal entries at the time bonds were issued.b. Amortization schedule showing the interest expense for the first three years.c. Journal entries for interest expense for the first two years.Use the time value of money tables given in this module.
Solution to Practice Problem 1, Agnew Company
a. Journal entry for issuance of the bondsInterest annuity = $6,000 per year ($50,000 x 0.12)Present value of the interest annuity = $6,000 x 5.35 = $32,100Present value of the face value = $50,000 x 0.47 = $23,500Total present value = $32,100 + $23,500 = $55,600Hence, the journal entry is
c. Journal entries for interest expenseAt the end of the first year:Date Account Debit Credit12/31/02 Interest Expense 5,560
Premium on Bonds Payable 440 Cash 6,000
At the end of the second year:Date Account Debit Credit12/31/03 Interest Expense 5,516
Premium on Bonds Payable 484 Cash 6,000
Practice Problem 2Shriver Company
Shriver Company issued bonds with a face value of $200,000 on January 1, 2002, at 98. The bonds had a call provision for 101, and on January 1, 2006, the company called back the bonds. By January 1, 2006, the discount on the bonds payable had been reduced by $1,000. Prepare the journal entries to record a. Issuance of the bonds on January 1, 2002b. Purchase and retirement of bonds on January 1, 2006.
Solution to Practice Problem 2, Shriver Company
a. Bonds were issued “at 98”, meaning the bonds were sold for 98% of the face value.Thus, the selling price of bonds = $200,000 x 0.98 = $196,000.Journal entry to record the sale of bonds
b. Call provision “for 101” means the bonds could be called for 101% of face value.Thus, the cash paid for the bonds = $200,000 x 1.01 = $202,000By January 1, 2006, the discount had been reduced by $1,000. Thus, the unamortized balance of Discount on Bonds Payable is $3,000.Journal entry to record the purchase and retirement of bonds
Debit CreditBonds Payable (step 2) 200,000Loss on Extinguishment of Debt (step 4) 5,000 Cash (step 1) 202,000 Discount on Bonds Payable (step 3) 3,000
Practice Problem 3Wallace Company
Wallace Company had issued 7-year, 12% bonds with a face value of $100,000 on January 1, 2002, at par. By 2004, the company had run into financial difficulties and did not pay $2,200 of the interest payment due on December 31, 2004. On January 1, 2005, the bonds were restructured as follows: the company would pay interest of $8,500 per year, and the maturity date would be extended to seven years from January 1, 2005 (the maturity value would remain the same $100,000). Prepare the journal entries to record the restructuring and the interest payment on December 31, 2005.
Solution to Practice Problem 3, Wallace Company
Step 1Total payments in the future = $100,000 + ($8,500 x 7).Since this is more than the amount owed at the time of the restructuring ($102,200), no gain on restructuring occurs.
Journal entry at the time of the restructuringDebit Credit
Step 2Calculate the implicit interest rate.$102,200 = Present value of a single sum of $100,000, seven years from now + Present value of interest annuity of $8,500 for seven years.By trial and error, using the tables given, we find the interest rate to be 8% per year[($100,000 x 0.58) + ($8,500 x 5.20) = $102,200].
Step 3Interest expense journal entries on December 31, 2005.Interest expense for the year = $102,200 x 0.08 = $ 8,176.
1. Bonds that are issued without any collateral are calleda. Junk bonds.b. Mortgage bonds.c. Debenture bonds.d. Callable bonds.
2. High-yield bonds are also calleda. Junk bonds.b. Mortgage bonds.c. Debenture bonds.d. Callable bonds.
3. The cash interest payments received by the bondholder are based on thea. Effective rate.b. Coupon rate.c. Stated rate.d. Both b and c.
4. If bonds are issued at a discount, thena. Cash received by the bond issuer equals the face value of the bonds.b. Cash received by the bond issuer is less than the face value of the bonds.c. Cash paid by the bondholder is more than the face value of the bonds.d. Cash received by the bond issuer is more than the face value of the bonds.
5. When bonds are issued at a premium,a. Stated rate of interest is more than the effective rate of interest.b. Stated rate of interest is less than the effective rate of interest.c. Stated rate of interest is equal to the effective rate of interest.d. Stated rate of interest is less than the yield for the bondholder.
6. When bonds are issued at a discount,a. The interest expense stays constant over time.b. The interest expense increases over time.c. The cash interest paid increases over time.d. The cash interest paid decreases over time.
7. When bonds are issued at a premium and the effective rate of premium amortization is used,a. The premium amortized increases over time.a. The premium amortized stays constant over time.c. The cash interest paid stays constant over time.d. Both a and c.
8. Boise Company issued bonds with a face value of $100,000 on January 1, 2002, at 101. On January 1, 2004, the company bought back the bonds for $99,000 through open market purchases and retired the bonds. If the balance of premium on the bonds was $500 at the time of the purchase, the company recordsa. an extraordinary loss of $1,500. b. an extraordinary loss of $ 500.c. an extraordinary gain of $1,500.d. none of the above.
Homework Problem 1Quayle Company
Quayle Company issued 8%, 7-year bonds with a face value of $30,000 on January 1, 2002. The effective interest rate on the bonds was 10%, and the interest is payable on December 31 each year. Prepare the following:a. Journal entries at the time bonds were issued.b. Amortization schedule showing the interest expense for the first three years.c. Journal entries for interest expense for the first two years.Use the time value of money tables given in this module.
Solution to Homework Problem 1, Quayle Company
a. Journal entry for issuance of the bondsInterest annuity = $2,400 per year ($30,000 x 0.08)Present value of the interest annuity = $2,400 x 4.90 = $11,760Present value of the face value = $30,000 x 0.51 = $15,300Total present value = $11,760 + $15,300 = $27,060Hence, the journal entry is
c. Journal entries for interest expenseAt the end of the first year:Date Account Debit Credit12/31/02 Interest Expense 2,706
Cash 2,400 Discount on Bonds Payable 306
At the end of the second year:Date Account Debit Credit12/31/03 Interest Expense 2,736
Cash 2,400 Discount on Bonds Payable 336
Homework Problem 2Bentsen Company
Bentsen Company issued bonds with a face value of $100,000 on January 1, 2002, at 102. On January 1, 2004, the company bought back the bonds for $99,000 through open market purchases. The balance of premium on the bonds was $1,500 at the time of the purchase. Prepare the journal entries to record a. Issuance of the bonds on January 1, 2002b. Purchase and retirement of bonds on January 1, 2005.
Solution to Demonstration Problem 2, Bentsen Company
a. Bonds were issued “at 102”, meaning the bonds were sold for 102% of the face value.Thus, the selling price of bonds = $100,000 x 1.02 = $102,000.Journal entry to record the sale of bonds
b. Journal entry to record the purchase and retirement of bondsDebit Credit
Bonds Payable (step 2) 100,000Premium on Bonds Payable (step 3) 1,500 Cash (step 1) 99,000 Gain on Extinguishment of Debt (step 4) 2,500
Homework Problem 3
1. Bonds that are issued with collateral are calleda. Junk bonds.b. Mortgage bonds.c. Debenture bonds.d. Callable bonds.
2. Bonds that can be redeemed by the issuer before the maturity date are calleda. Junk bonds.b. Mortgage bonds.c. Debenture bonds.d. Callable bonds.
3. The interest rate actually earned by the bondholders is called thea. Effective rate.b. Coupon rate.c. Stated rate.d. Both b and c.
4. If bonds are issued at a premium, thena. Cash received by the bond issuer equals the face value of the bonds.b. Cash paid by the bondholder is less than the face value of the bonds.c. Cash received by the bond issuer is more than the face value of the bonds.d. Cash received by the bond issuer is less than the face value of the bonds.
5. When bonds are issued at a discount,a. Stated rate of interest is more than the effective rate of interest.b. Stated rate of interest is less than the effective rate of interest.c. Stated rate of interest equals the effective rate of interest.d. Effective rate of interest is less than the yield for the bondholder.
6. When bonds are issued at a premium,a. The interest expense increases over time.b. The interest expense decreases over time.c. The cash interest paid increases over time.d. The cash interest paid decreases over time.
7. When bonds are issued at a discount and the effective rate of discount amortization is used,a. The discount amortized increases over time.a. The discount amortized decreases constant over time.c. The cash interest paid increases over time.d. Both a and c.
8. Dakota Company issued bonds with a face value of $100,000 on January 1, 2002, at 98. On January 1, 2004, the company bought back the bonds for $99,000 through open market purchases and retired the bonds. If the balance of discount on the bonds was $500 at the time of the purchase, the company recordsa. an extraordinary gain of $ 500. b. an extraordinary loss of $ 500.c. an extraordinary gain of $1,500.d. none of the above.
Present and Future values (rounded for ease of use)6% per period 8% per period
Number of periods Number of periods6 7 8 9 10 6 7 8 9 10
PVSS 0.71 0.67 0.63 0.60 0.56 0.63 0.58 0.54 0.50 0.46 PVOA 4.90 5.60 6.20 6.80 7.40 4.60 5.20 5.75 6.25 6.70PVAD 5.20 5.90 6.60 7.20 7.80 5.00 5.60 6.20 6.75 7.25FVSS 1.40 1.50 1.60 1.70 1.80 1.60 1.70 1.85 2.00 2.15FVOA 7.00 8.40 9.90 11.50 13.20 7.30 8.90 10.60 12.50 14.50FVAD 7.40 8.90 10.50 12.20 14.00 7.90 9.60 11.50 13.50 15.70Note:PVSS = Present value of a single sumPVOA = Present value of an ordinary annuityPVAD = Present value of an annuity dueFVSS = Future value of a single sumFVOA = Future value of an ordinary annuityFVAD = Future value of an annuity due
Present and Future values (rounded for ease of use)10% per period 12% per period
Number of periods Number of periods6 7 8 9 10 6 7 8 9 10
PVSS 0.56 0.51 0.47 0.42 0.39 0.50 0.45 0.40 0.36 0.32PVOA 4.35 4.90 5.35 5.75 6.10 4.10 4.50 5.00 5.30 5.70PVAD 4.80 5.35 5.90 6.33 6.75 4.60 5.10 5.60 6.00 6.33FVSS 1.80 1.95 2.15 2.35 2.60 2.00 2.20 2.50 2.75 3.10FVOA 7.70 9.50 11.40 13.60 15.90 8.10 10.10 12.30 14.80 17.50FVAD 8.50 10.40 12.60 14.90 17.50 9.10 11.30 13.80 16.50 19.60Note:PVSS = Present value of a single sumPVOA = Present value of an ordinary annuityPVAD = Present value of an annuity dueFVSS = Future value of a single sumFVOA = Future value of an ordinary annuityFVAD = Future value of an annuity due
