Intermediate Accounting Exam 1 - Chapter 14

Calculation of interest expense using effective-interest and straight-line methods

- straight-line amortizes a constant amount each interest period (total discount or premium / total number of periods)

Effective interest method - Bonds issued at discount Evermaster Corporation issued $100,000 of 8 percent term bonds on January 1, 2017, due on January 1, 2022, with interest payable each July 1 and January 1. Because the investors required an effective-interest rate of 10 percent, they paid $92,278 for the $100,000 of bonds, creating a $7,722 discount. Evermaster computes the $7,722 discount as follows

1. Find PV of bond due - n=10 (5 years x semiannual payments)= 10, i= (10%/semiannual) = 5% --> 0.61391 - (100,000 x 0.61391) = 61,391 b. Find interest payment (100,000 x 0.08) = 8,000 / 2 semiannual payments = 4,000 c. Find PV of interest payment - PV annuity due (n=10, i=5%) = 7.72173 (4,000 x 7.72173) = 30,887 d. Subtract proceeds from sale of bonds; discount on bonds payable (61,391+30,887) - (92,278) = 7,722

Bonds issued at discount Buchanan Company issues the $800,000 of bonds on January 1, 2017, at 97 (meaning 97% of par), it records the following issuan

1. Find cash amount received (800,000 x 0.97) = 776,000 - (800,000 - 776,000) = 24,000 discount Debit: Cash 776,000 Debit: Discount on B/P 24,000 Credit: Bonds payable 800,000 2. Find amount that is amortized to interest expense each period (24,000/20) = 1,200 b. Find semiannual interest payment amount (800,000 x 0.10 x 6/12) = 40,000 c. Record interest expense on 7/1/17 and 12/31/17 - Debit: Interest expense 40,000 Credit - Discount on B/P 1,200 - Cash 40,000

Bonds issued at premium - example Evermaster Corporation, investors are willing to accept an effective-interest rate of 6 percent. In that case, they would pay $108,530 or a premium of $8,530, computed as follows. -maturity value = 100,000 - semiannual payments - 5 years due - 8% stated rate

1. Find premium on bonds payable - Maturity value 100,000 - PV 100,000 due in 5 years at 6% (100,000 x 0.74409) = 74,409 - PV 4,000 interest payment (100,000 x 0.08 / 2) = 4,000 (4,000 x 8.53020) = 34,121 - Less (108,530) proceeds from sale ---------------------------------------- Premium on B/P: 8,530 2. Record issuance of bond on 1/1/17 Debit: Cash 108,530 Credit: - Premium on B/P 8,530 - Bonds payable 100,000 3. Find interest payment and premium amortized for 7/1/17 (108,530 x 0.03) = 3,256 (4000 - 3256) = 744 Debit: - Interest expense 3,256 - Premium on B/P 744 Credit: - Cash 4,000

Bonds issued at Par on interest date Buchanan Company issues at par 10-year term bonds with a par value of $800,000, dated January 1, 2017, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the following entry

1. Record issuance of bond - Debit: Cash 800,000 - Credit: B/P 800,000 2. Record 1st semiannual interest payment (800,000 x 0.10 x 6/12) = 40,000 - Debit: Interest expense 40,000 - Credit: Cash 40,000 3. Record accrued interest expense at 12/31/17 - Debit: Interest expense 40,000 - Credit interest payable 40,000

Bonds represent a promise to pay

1. a sum of money at a designated maturity date 2. periodic interest at a specified rate on the maturity amount (face value)

Bonds issued at a premium Premium on Bonds Payable is accounted for in a manner similar to that for Discount on Bonds Payable. If Buchanan dates and sells 10-year bonds with a par value of $800,000 on January 1, 2017, at 103, it records the issuance as follows

1. find amount of cash that is to be received (800,000 x 1.03) = 824,000 b. find premium on b/p (824,000 - 800,000) = 24,000 c. Record entry on 1/1/17 Debit: cash 824,000 Credit - Premium on B/P 24,000 - Cash 800,000 2. Amortized interest expense each period (24,000/20) = 1,200 b. find semiannual interest payment - (800,000 x 0.10 x 6/12) = 40,000 c. Record journal entry for first semiannual payment Debit - Interest expense 38,800 - Premium on B/P 1,200 Credit - cash 40,000

Evermaster Corporation issued $100,000 of 8 percent term bonds on January 1, 2017, due on January 1, 2022, with interest payable each July 1 and January 1. Because the investors required an effective-interest rate of 10 percent, they paid $92,278 for the $100,000 of bonds, creating a $7,722 discount. Evermaster computes the $7,722 discount as follows - record journal entries for issuance of bonds at discount, first interest payment, and interest expense accrued at 12/31/17

1. record issuance at 1/1/17 Debit- Cash 92,278 Debit - Discount B/P 7,722 Credit: Cash 100,000 2. record first interest payment 7/1/17 *use 5%, since effective yield is 10% but you make semiannual payments (92,278 x 0.05) = 4614 discount amortized (4614 - 4000) = 614 Debit: Interest expense 4614 Credit: - discount on B/P 614 - Cash 4,000 3. Record interest expense accrued at 12/31 and amortization of discount (92,278 + 614 = 92,892) - (92,892 x 0.05) = 4645 - discount amortized (4645 - 4000) = 645 Debit: Interest expense 4645 Credit - Discount on b/p 645 - interest payable 4,000

Examples of long-term liabilities

B/P, long-term notes payable, mortgage payable, zero-interest bearing notes

Early retirement of bonds 1/1/10, GBCo issued at 95 bonds with a par value of 800,000, due in 20 years. Eight years after the issue date, GBCo calls the entire issue at 101 and cancels it. At the time, the unamortized discount balance is 24,000/. GBCo computes the loss on redemption as follows

Cash paid calculation (800,000 x 1.01) = 808,000 Net carrying amount of bonds redeemed: - Face value = 800,000 - Unamortized discount (40,000 x 12/20) = 24,000 (808,000 - (800,000 - 24000)) = 776,000 ----------------------------------- Loss on redemption 32,000 b. Journal entry Debit: Bonds payable 800,000 Loss on redemption 32,000 Credit: Discount on B/P 24,000 Cash 808,000

Bearer bond

not recorded in the name of the owner and may be transferred from one owner to another by mere delivery - aka coupon bond

Discount vs premium bonds

Discount: bond sells for less than the face value - effective yield > stated rate Premium: bond sells for more than the face value - effective yield < stated rate

If my stated interest rate is 8%... a) market interest rate = 6% b) market interest rate = 8% c) market interest rate = 10%

a) bond sold at premium b) bond sold at par value c) bond sold at discount

Serial bond

bond issues that mature in installments - used by school districts, municipalities, local taxing bodies that receive money through a levy

Term bond

bond issues that mature on a single date

Calculating bond prices using the present value of cash flows

bonds are valued at the present value of its expected future cash flows - consists of 1) interest and 2) principal

Registered bond

bonds issued in the name of the owner - require surrender of certificate and issuance of a new certificate to complete a sale

Bonds issued between interest dates

buyers of the bond will pay the seller the interest accrued from the last interest payment date to the date of issue - on the next semiannual interest payment date, purchasers receive the full six months interest payment

Issues 10-year bonds, dates 1/1/17, with a par value of 800,000. Annual interest rate of 6%, payable semiannually on 1/1 and 7/1. *Taft issued the 6 percent bonds at 102, its March 1 entry would be:

calculate cash received (800,000 x 1.02) = 816,000 calculate premium on bonds payable (800,000 x 0.02) = 16,000 calculate interest expense (800,000 x 0.06 x 1/12) = 4,000 - (4,000 x 2 months) = 8,000 Record journal entry Debit: Cash 824,000 Credit: - Bonds payable 800,000 - Premium on B/P 16,000 - Interest expense 8,000

Issued between interest dates example March 1, 2017, Taft Corporation issues 10-year bonds, dated January 1, 2017, with a par value of $800,000. These bonds have an annual interest rate of 6 percent, payable semiannually on January 1 and July 1. . Because Taft issues the bonds between interest dates, it records the bond issuance at par plus accrued interest as follows b)The purchaser advances 2 months interest. On July 1, 2017, four months after the date of purchase, Taft pays the purchaser six months' interest. Taft makes the following entry on July 1, 2017.

calculate interest expense (800,000 x 0.06 x 2/12) = 8,000 1. Record bond issuance at par plus accrued interest Debit: Cash 808,000 Credit: - Bonds payable 800,000 - Interest expense 8,000 B) Calculate interest expense (800,000 x 0.06 x 1/12) = 4,000 - 4,000 x 6 months = 24,000 Debit: Interest expense 24,000 Credit: Cash 24,000

Amortization of a premium -- interest expense

decreases

Effective interest method produces a periodic interest expense ...

equal to a constant percentage of the carrying value of the bonds - more relevant measure of interest expense

Calculation of carrying value of bonds

face amount of a bond (--) any unamortized discount OR (+) any unamortized premium

effective-interest method: bond interest paid calculation

face amount of the bonds times the stated interest rate

Fair value - Net income Edmonds Company has issued $500,000 of 6 percent bonds at face value on May 1, 2017. Edmonds chooses the fair value option for these bonds. At December 31, 2017, the value of the bonds is now $480,000 because interest rates in the market have increased to 8 percent a. record the entry

if changes in interest rates occur, the fair value of a company's financial liabilities changes as well *reduces bond liability which means Edmonds has to repay less than before; results in gain Debit - Bond payable 20,000 Credit - unrealized holding gain -- income 20,000

Fair value - other comprehensive income Edmonds Company fair value change on its bonds is due to its credit rating dropping from AA to BB. In this case, Edmonds makes the following entry to record the fair value change in other comprehensive income

if creditworthiness of company declines, the value of its debt also declines *doesn't affect income* Bonds payable 20,000 Unrealized holding gain or loss -- equity 20,000

Amortization of a discount -- interest expense

increases

Effective-interest method accrued interest : Prorate Edmonds prepares financial statements at the end of Feb 2017?

interest accrual (4000 x 2/6) = 1,333.33 Premium amortized (744 x 2/6) = 248 --------------------------------- Interest expense (Jan-Feb) = 1,085.33 Journal entry Debit: interest expense 1085.33 Debit: premium on B/P 248 Credit: Interest payable 1,333.33

stated rate

interest rate written in the terms of the bond indenture - issuer of bond sets this rate - % of face value of the bonds

How changes in interest rate effects bond prices

inverse relationship between market interest rate and price of the bond - Bond sells for less than face value: investors demand higher rate of interest than the stated rate - Bond sells for more than face value: lower interest rate than stated rate

Zero-interest bearing notes

measures PV by cash received - records difference between face amount and PV as a discount and amortizes that amount to interest expense over the life of the note

Effective-interest method: interest expense calculation

multiply the carrying value of the bonds at the beginning of the period by the effective interest rate

effective interest method

preferred procedure for computing the amortization of a discount or premium - compute bond interest expense at the beginning of the period and then subtract bond interest paid which results in amortization amount

Long-term liabilities

probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer

effective yield

rate of interest bondholders actually earn on a bond

Implicit interest rate

rate that equates the cash received with the amounts to be paid in the future

Fair value option

recording of financial assets or financial liabilities at fair value with unrealized holding gains and losses reported as part of net income

Different types of bonds

term, serial, registered, bearer