Demonstration Problem Accounting What the Numbers Mean 10e Demonstration Problem Chapter 7 – Problem 31 Bonds Payable – Calculate Issue Price and Amortize Discount

Problem Definition On January 1, 2013, Drennen, Inc., issued $3 million face amount of 10-year, 14% stated rate bonds when market interest rates were 12%. The bonds pay semiannual interest each June 30 and December 31 and mature on December 31, 2022.

Problem Definition Using the present value tables in Chapter 6, calculate the proceeds (issue price) of Drennen, Inc.’s, bonds on January 1, 2013, assuming that the bonds were sold to provide a market rate of return to the investor. Assume instead that the proceeds were $2,950,000. Use the horizontal model (or write the journal entry) to record the payment of semiannual interest and the related discount amortization on June 30, 2013, assuming that the discount of $50,000 is amortized on a straight-line basis. If the discount in part b were amortized using the compound interest method, would interest expense for the year ended December 31, 2013, be more than, less than, or equal to the interest expense reported using the straight-line method of discount amortization? Explain.

Problem Solution a. The semi-annual interest payments on the bonds =

Problem Solution a. The semi-annual interest payments on the bonds = Stated Rate

Problem Solution a. The semi-annual interest payments on the bonds = Stated Rate 14%

Problem Solution a. The semi-annual interest payments on the bonds = Stated Rate * Face amount 14%

Problem Solution a. The semi-annual interest payments on the bonds = Stated Rate * Face amount 14% * $3,000,000

Problem Solution a. The semi-annual interest payments on the bonds = Stated Rate * Face amount * Period = 14% * $3,000,000

Problem Solution a. The semi-annual interest payments on the bonds = Stated Rate * Face amount * Period = 14% * $3,000,000 * 6/12 =

Problem Solution a. The semi-annual interest payments on the bonds = Stated Rate * Face amount * Period = 14% * $3,000,000 * 6/12 = $210,000 This amount represents the cash interest payment that is due to the bondholder of record every six months throughout the life of the bond. This is true whether the bond is sold at a premium, at a discount, or at par.

Problem Solution The term of the bond is 10 years,

Problem Solution The term of the bond is 10 years, or 20 semi-annual periods.

Problem Solution The term of the bond is 10 years, or 20 semi-annual periods. The semi-annual market interest rate =

Problem Solution The term of the bond is 10 years, or 20 semi-annual periods. The semi-annual market interest rate = 12%

Problem Solution The term of the bond is 10 years, or 20 semi-annual periods. The semi-annual market interest rate = 12% * 6/12 =

Problem Solution The term of the bond is 10 years, or 20 semi-annual periods. The semi-annual market interest rate = 12% * 6/12 = 6% This is the interest rate used to discount the semi-annual cash interest payments of $210,000 each (i.e., the annuity) back to present value.

Problem Solution The present value of an annuity of $210,000 for 20 periods at 6% =

Problem Solution The present value of an annuity of $210,000 for 20 periods at 6% = $210,000 The semi-annual interest payment of $210,000 is…

Problem Solution The present value of an annuity of $210,000 for 20 periods at 6% = $210,000 * 11.4699 = The semi-annual interest payment of $210,000 is… multiplied by the present value of an annuity factor (n = 20, i = 6%) from Table 6-5 in the text…

Problem Solution The present value of an annuity of $210,000 for 20 periods at 6% = $210,000 * 11.4699 = $2,408,679 The semi-annual interest payment is… multiplied by the present value of an annuity factor (n = 20, i = 6%) from Table 6-5 in the text… to get the present value of the interest annuity.

Problem Solution The present value of the maturity amount of $3,000,000 in 20 periods at 6% =

Problem Solution The present value of the maturity amount of $3,000,000 in 20 periods at 6% = $3,000,000 The par value of the bonds, which will be paid to the bondholder of record on the maturity date, is…

Problem Solution The present value of the maturity amount of $3,000,000 in 20 periods at 6% = $3,000,000 * 0.3118 = The par value of the bonds, which will be paid to the bondholder of record on the maturity date, is… multiplied by the present value of $1 factor (n = 20, i = 6%) from Table 6-4 in the text…

Problem Solution The present value of the maturity amount of $3,000,000 in 20 periods at 6% = $3,000,000 * 0.3118 = $935,400 The par value of the bonds, which will be paid to the bondholder of record on the maturity date, is… multiplied by the present value of $1 factor (n = 20, i = 6%) from Table 6-4 in the text… to get the present value of the maturity amount.

Problem Solution The proceeds (issue price) of the bonds =

Problem Solution The proceeds (issue price) of the bonds = PV of interest

Problem Solution The proceeds (issue price) of the bonds = PV of interest $2,408,679

Problem Solution The proceeds (issue price) of the bonds = PV of interest + PV of maturity value = $2,408,679

Problem Solution The proceeds (issue price) of the bonds = PV of interest + PV of maturity value = $2,408,679 + $935,400 =

Problem Solution The proceeds (issue price) of the bonds = PV of interest + PV of maturity value = $2,408,679 + $935,400 = $3,344,079

Problem Definition Using the present value tables in Chapter 6, calculate the proceeds (issue price) of Drennen, Inc.’s, bonds on January 1, 2013, assuming that the bonds were sold to provide a market rate of return to the investor. Assume instead that the proceeds were $2,950,000. Use the horizontal model (or write the journal entry) to record the payment of semiannual interest and the related discount amortization on June 30, 2013, assuming that the discount of $50,000 is amortized on a straight-line basis. If the discount in part b were amortized using the compound interest method, would interest expense for the year ended December 31, 2013, be more than, less than, or equal to the interest expense reported using the straight-line method of discount amortization? Explain.

Problem Solution b. The semiannual discount amortization, straight-line basis =

Problem Solution b. The semiannual discount amortization, straight-line basis = $50,000

Problem Solution b. The semiannual discount amortization, straight-line basis = $50,000 / 20 periods =

Problem Solution b. The semiannual discount amortization, straight-line basis = $50,000 / 20 periods = $2,500

Problem Solution b. Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses

Problem Solution b. Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses Cash -210,000 The cash payment of $210,000 each six months represents the par value of $3,000,000 times the market rate of interest of 12% times the period of time of 6/12.

Problem Solution b. Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses Cash Discount on -210,000 Bonds Payable +2,500 The amortization of bond discount increases the carrying value of the bonds from $3,000,000 - $50,000 = $2,950,000 to $3,000,000 - $47,500 = $2,952,500.

Problem Solution b. Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses Cash Discount on Interest -210,000 Bonds Payable Expense +2,500 -212,500 When bond discount is amortized, interest expense is the sum (or addition) of the cash interest payment and the discount amortized.

Problem Solution b. Cash Discount on Interest Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses Cash Discount on Interest -210,000 Bonds Payable Expense +2,500 -212,500 Journal entry: Dr. Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . $212,500

Problem Solution b. Cash Discount on Interest Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses Cash Discount on Interest -210,000 Bonds Payable Expense +2,500 -212,500 Journal entry: Dr. Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . $212,500 Cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000

Problem Solution b. Cash Discount on Interest Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses Cash Discount on Interest -210,000 Bonds Payable Expense +2,500 -212,500 Journal entry: Dr. Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . $212,500 Cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000 Cr. Discount on Bonds Payable . . . . . . . . . . . . . . 2,500

Problem Solution b. Balance Sheet Income Statement . Assets = Liabilities + Stockholders’ Equity  Net income = Revenues - Expenses Cash Discount on Interest -210,000 Bonds Payable Expense +2,500 -212,500 Journal entry: Dr. Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . $212,500 Cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000 Cr. Discount on Bonds Payable . . . . . . . . . . . . . . 2,500 The interest expense debit is the sum (or addition) of the Cash and Discount on Bonds Payable credits.

Problem Definition Using the present value tables in Chapter 6, calculate the proceeds (issue price) of Drennen, Inc.’s, bonds on January 1, 2013, assuming that the bonds were sold to provide a market rate of return to the investor. Assume instead that the proceeds were $2,950,000. Use the horizontal model (or write the journal entry) to record the payment of semiannual interest and the related discount amortization on June 30, 2013, assuming that the discount of $50,000 is amortized on a straight-line basis. If the discount in part b were amortized using the compound interest method, would interest expense for the year ended December 31, 2013, be more than, less than, or equal to the interest expense reported using the straight-line method of discount amortization? Explain.

Problem Solution Discount on bonds payable is amortized with a credit, and thus increases interest expense.

Problem Solution c. Discount on bonds payable is amortized with a credit, and thus increases interest expense. Under the straight-line basis, the amount of discount amortization is the same each period.

Problem Solution Discount on bonds payable is amortized with a credit, and thus increases interest expense. Under the straight-line basis, the amount of discount amortization is the same each period. Under the compound (or effective) interest method, the amount of discount amortization increases each period.

Problem Solution Discount on bonds payable is amortized with a credit, and thus increases interest expense. Under the straight-line basis, the amount of discount amortization is the same each period. Under the compound (or effective) interest method, the amount of discount amortization increases each period. Thus, interest expense under the compound method will be lower in the early years of the bond’s life, and higher in the later years, as compared to interest expense under the straight-line method of amortization.

Accounting What the Numbers Mean 10e David H. Marshall You should now have a better understanding of how to account for bonds payable. Remember that there is a demonstration problem for each chapter that is here for your learning benefit. David H. Marshall Wayne W. McManus Daniel F. Viele