Exercises. The bond is being issued at a premium, and the selling price would be higher than the face amount.

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1 Chapter 11 Liabilities: Bonds Payable Study Guide Solutions Fill-in-the-Blank Equations 1. A discount 2. The face amount 3. A premium 4. Interest expense Exercises 1. Roses Corporation issued a bond with a contract interest rate of 10%. The current market rate of a bond is 9%. Is the bond being issued at a discount, a premium, or the face amount? Would the selling price be higher or lower than the face amount? The bond is being issued at a premium, and the selling price would be higher than the face amount. 2. The Garden Supply issued a $1,000,000 bond for $975,000. Would the contract rate be higher or lower than the market rate? Is the bond being issued at a discount, a premium, or the face amount? The bond is being issued at a discount, and the contract rate would be lower than the market rate. 3. If The Garden Supply issued a $5,000,000 bond with the same market rate as the contract rate, how much cash would the company receive for the bond? Is the bond being issued at a discount, a premium, or the face amount? The company would receive $5,000,000 for the bond because it is being issued at the face amount. Strategy: A bond issued at its face amount means that the contract rate is equal to the market rate, so the amount of cash received is equal to the bond payable. If a premium exists, the contract rate is higher than the market rate, so investors are willing to pay more for the bond. However, if the contract rate is lower than the market rate, investors will only want to invest if they have an incentive, such as a discount. 1

2 2 Chapter The Howling Moon issued $2,500,000 of five-year, 10% bonds at par value on January 1, 20Y5. Interest is payable semiannually, on June 30 and December 31. Prepare the journal entries related to the following: a. Issuance of the bonds Jan. 1 Cash 2,500,000 Bonds Payable 2,500,000 b. Interest expense on June 30, 20Y5 June 30 Interest Expense 125,000 Cash 125,000 Interest expense: $2,500,000 10% ½ year c. Retirement of the bonds Jan. 1 Bonds Payable 2,500,000 Cash 2,500, Burns Alley issued $1,000,000 of 10-year, 8% bonds at par value on June 30, 20Y5. The interest is payable annually, beginning on January 1 of the following year. Prepare the journal entries related to the following: a. Issuance of the bonds June 30 Cash 1,000,000 Bonds Payable 1,000,000 b. Interest expense on January 1, 20Y6 Jan. 1 Interest Expense 80,000 Cash 80,000 Interest expense: $1,000,000 8% c. Retirement of the bonds June 30 Bonds Payable 1,000,000 Cash 1,000,000

3 Liabilities: Bonds Payable 3 6. RPC Corporation issued $4,000,000 of two-year, 12% bonds at par value on September 30, 20Y5. The interest is payable every quarter, starting on December 31, 20Y5. Prepare the journal entries for the following: a. Issuance of the bonds Sept. 30 Cash 4,000,000 Bonds Payable 4,000,000 b. Interest expense on January 1, 20Y6 Jan. 1 Interest Expense 120,000 Cash 120,000 Interest expense: $4,000,000 12% ¼ year c. Retirement of the bonds Sept. 30 Bonds Payable 4,000,000 Cash 4,000,000 Strategy: When bonds are issued at par, the cash received is equal to the face amount of the bond; therefore, a premium or discount will not be recorded and amortized. The interest expense is equal to the contract rate multiplied by the face amount of the bond.

4 4 Chapter 11 Payment Date 7. Shem Creek Corp. issued $200,000 of five-year, 9% bonds for $192,298 on January 1, 20Y5. The interest is payable semiannually on June 30 and December 31, beginning on June 30, 20Y5. The market rate at the time of issuance is 10%. Calculate the amount of interest expense and amortization of the discount recorded for the first fiscal year ending December 31, 20Y5, using the: a. Straight-line method for amortization Discount on bonds payable $7,702 Term of bonds 5 years Semiannual amortization ($7, periods) $ Interest expense: ($9, $770.20) 2 periods = $19, Amortization of discount: $ periods = $1, b. Effective interest rate method for amortization Int. Paid (Face 9% ½) Int. Exp. (Carrying Amount 10% ½) Disc. Amortization (Int. Exp. Int. Paid) Unamortized Disc. Bond Carrying Amount $7, $192, June 30 $9,000 $9, $ , , Dec. 31 9,000 9, , , Interest expense: $9, $9, = $19, Amortization of discount: $ $ = $1,260.50

5 Liabilities: Bonds Payable 5 8. Prepare the journal entries for the issuance, interest payments for the first year, and retirement of the bonds for Shem Creek Corp. using the information in Exercise 7. Assume the company uses the effective interest rate method to amortize the bond discount. Issuance: Interest payments: Retirement: Jan. 1 Cash 192, Discount on Bonds Payable 7, Bonds Payable 200, June 30 Interest Expense 9, Discount on Bonds Payable Cash 9, Dec. 31 Interest Expense 9, Discount on Bonds Payable Cash 9, Jan. 1 Bonds Payable 200, Cash 200,000.00

6 6 Chapter 11 Payment Date 9. Cooper River Corporation issued $1,000,000 of five-year, 8% bonds for $922,780 at the beginning of its fiscal year on July 1, 20Y5, when the market rate is 10%. The interest is payable semiannually, beginning December 31, 20Y5. Calculate the interest expense and discount amortization for the first fiscal year using the: a. Straight-line method for amortization Discount on bonds payable $77,220 Term of bonds 5 years Semiannual amortization ($77, periods) $7,722 Interest expense: ($7,722 + $40,000) 2 periods = $95,444 Amortization of discount: $7,722 2 periods = $15,444 b. Effective interest rate method for amortization (round answers to the nearest dollar) Int. Paid (Face 8% ½) Int. Exp. (Carrying Amount 10% ½) Disc. Amortization (Int. Exp. Int. Paid) Unamortized Disc. Bond Carrying Amount $77, $922, Dec. 31 $40,000 $46, $6, , , June 30 40,000 46, , , , Interest expense: $46, $46, = $92, Amortization of discount: $6, $6, = $12,584.95

7 Liabilities: Bonds Payable Prepare the journal entries required for the issuance, interest payments for the first year, and retirement of the bonds for Cooper River Corporation using the information in Exercise 9. Assume the company accounts for the bond discount using the straight-line method. Issuance: Interest payments: Retirement: July 1 Cash 922,780 Discount on Bonds Payable 77,220 Bonds Payable 1,000,000 Dec. 31 Interest Expense 47,722 Discount on Bonds Payable 7,722 Cash 40,000 June 30 Interest Expense 47,722 Discount on Bonds Payable 7,722 Cash 40,000 July 1 Bonds Payable 1,000,000 Cash 1,000,000

8 8 Chapter 11 Payment Date 11. On January 1, 20Y5, Terese Corporation issued $2,000,000 of three-year, 13% bonds for $1,952, Interest on the bonds is payable semiannually, on June 30 and December 31. On the date of issuance, the market rate of bonds was 14%. Calculate the interest expense and bond amortization for the first fiscal year using the: a. Straight-line method for amortization Discount on bonds payable $47, Term of bonds 3 years Semiannual amortization ($47, periods) $7, Interest expense: ($7, $130,000.00) 2 periods = $275, Amortization of discount: $7, periods = $15, b. Effective interest rate method for amortization Int. Paid (Face 13% ½) Int. Exp. (Carrying Amount 14% ½) Disc. Amortization (Int. Exp. Int. Paid) Unamortized Disc. Bond Carrying Amount $47, $1,952, June 30 $130,000 $136, $6, , ,958, Dec , , , , ,966, Interest expense: $136, $137, = $273, Amortization of discount: $6, $7, = $13, Strategy: If a bond is issued at a discount, the investors are essentially receiving interest for not paying the full amount of the bond, so the amortization of the discount should be added to the interest paid by the corporation to calculate the interest expense. The amount of interest expense and discount amortization depends upon the method used, with the straight-line method giving the same interest expense every period, and the effective interest rate method varying over time.

9 Liabilities: Bonds Payable Using the information in Exercise 11, prepare the journal entries to record the issuance, interest payments for the first year, and retirement of the bonds for Terese Corporation. Assume that the company uses the effective interest rate method to account for the amortization. Issuance: Jan. 1 Cash 1,952, Discount on Bonds Payable 47, Bonds Payable 2,000, Interest payments: Retirement: June 30 Interest Expense 136, Discount on Bonds Payable 6, Cash 130, Dec. 31 Interest Expense 137, Discount on Bonds Payable 7, Cash 130, Jan. 1 Bonds Payable 2,000, Cash 2,000, Strategy: Upon issuance, the discount on the bonds should be debited to show that the amount of cash received is less than the amount owed to the bondholders. When recording an interest expense, the discount will be amortized by crediting Discount on Bonds Payable, which reduces the account. Upon retirement, the bond will be fully amortized. Debit Bonds Payable for the face amount and credit Cash for the same amount, which will be paid to the bondholders.

10 10 Chapter 11 Payment Date 13. Trends Inc. issued $1,000,000 of five-year, 9% bonds on January 1, 20Y5, for $1,041,000. The bonds will pay interest semiannually, beginning on June 30, 20Y5. The market rate at the date of issuance was 8%. Calculate the interest expense and bond amortization for the first fiscal year using the: a. Straight-line method for amortization Premium on bonds payable $41,000 Term of bonds 5 years Semiannual amortization ($41, periods) $4,100 Interest expense: ($45,000 $4,100) 2 periods = $81,800 Amortization of premium: $4,100 2 periods = $8,200 b. Effective interest rate method for amortization Int. Paid (Face 9% ½) Int. Exp. (Carrying Amount 8% ½) Prem. Amortization (Int. Paid Int. Exp.) Unamortized Prem. Bond Carrying Amount $41, $1,041, June 30 $45,000 $41, $3, , ,037, Dec ,000 41, , , ,034, Interest expense: $41, $41, = $83, Amortization of premium: $3, $3, = $6,854.40

11 Liabilities: Bonds Payable Using the information in Exercise 13, prepare the journal entries to record the issuance, interest payments for the first year, and retirement of the bonds for Trends Inc. Assume that the company uses the effective interest rate method to account for the amortization. Issuance: Jan. 1 Cash 1,041, Premium on Bonds Payable 41, Bonds Payable 1,000, Interest payments: Retirement: June 30 Interest Expense 41, Premium on Bonds Payable 3, Cash 45, Dec. 31 Interest Expense 41, Premium on Bonds Payable 3, Cash 45, Jan. 1 Bonds Payable 1,000, Cash 1,000,000.00

12 12 Chapter 11 Payment Date 15. Fast Tires issued $5,000,000 of five-year, 10% bonds on June 30, 20Y5, for $5,405,550. The bonds pay interest quarterly, beginning September 30, 20Y5. At the date of issuance, the market rate was 8%. Calculate the interest expense and bond amortization for the first fiscal year using the: a. Straight-line method for amortization Premium on bonds payable $405,550 Term of bonds 5 years Quarterly amortization ($405, periods) $20, Interest expense: ($125, $20,277.50) 4 periods = $418, Amortization of premium: $20, periods = $81, b. Effective interest method for amortization Int. Paid (Face 10% ¼) Int. Exp. (Carrying Amount 8% ¼) Prem. Amortization (Int. Paid Int. Exp.) Unamortized Prem. Bond Carrying Amount $405, $5,405, Sept. 30 $125,000 $108, $16, , ,388, Dec , , , , ,371, Mar , , , , ,353, June , , , , ,335, Interest expense: $108, $107, $107, $107, = $430, Amortization of premium: $16, $17, $17, $17, = $69,609.84

13 Liabilities: Bonds Payable Use the information in Exercise 15 to prepare the journal entries to record the issuance, first interest payment, and retirement of the bonds for Fast Tires. Assume the company uses the straight-line method for amortization. Issuance: June 30 Cash 5,405, Premium on Bonds Payable 405, Bonds Payable 5,000, Interest payment: Retirement: Sept. 30 Interest Expense 104, Premium on Bonds Payable 20, Cash 125, June 30 Bonds Payable 5,000, Cash 5,000,000.00

14 14 Chapter 11 Payment Date 17. Tortoise Cleaning Corporation issued $250,000 of five-year, 7% bonds payable for $271,880 on January 1, 20Y5. The bonds will pay interest semiannually, beginning on June 30, 20Y5. At the time of issuance, the market rate was 5%. Calculate the interest expense and bond amortization for the first year using the: a. Straight-line method for amortization Premium on bonds payable $21,880 Term of bonds 5 years Semiannual amortization ($21, periods) $2,188 Interest expense: ($8,750 $2,188) 2 periods = $13,124 Amortization of premium: $2,188 2 periods = $4,376 b. Effective interest rate method for amortization Int. Paid (Face 7% ½) Int. Exp. (Carrying Amount 5% ½) Prem. Amortization (Int. Paid Int. Exp.) Unamortized Prem. Bond Carrying Amount $21, $271, June 30 $8,750 $6, $1, , , Dec. 31 8,750 6, , , , Strategy: If a bond is issued at a premium, the corporation will have to pay more in interest than the market rate. The amortization of the premium should be subtracted from the interest paid to calculate interest expense for the period.

15 Liabilities: Bonds Payable Use the information in Exercise 17 to prepare the journal entries to record the issuance, first interest payment, and retirement of the bonds for Tortoise Cleaning Corporation, assuming the company uses the straight-line method for amortization. Issuance: Interest payment: Retirement: Jan. 1 Cash 271,880 Premium on Bonds Payable 21,880 Bonds Payable 250,000 June 30 Interest Expense 6,562 Premium on Bonds Payable 2,188 Cash 8,750 Jan. 1 Bonds Payable 250,000 Cash 250,000 Strategy: When recording the issuance of a bond at a premium, credit Premium on Bonds Payable to show that the corporation received more cash than will be paid back at retirement. Over time, the premium will be amortized, which should be recorded by debiting Premium on Bonds Payable. At the time of retirement, the premium will be fully amortized. Debit Bonds Payable for the face amount and credit Cash for the same amount, which is also the amount paid to the investors. 19. On March 31, RPC Corporation redeems one-half of the outstanding bonds payable for $62,500. The total bonds outstanding had a face amount of $120,000 and an unamortized premium of $7,500. Prepare the journal entry to record the redemption. Mar. 31 Bonds Payable 60,000 Premium on Bonds Payable 3,750 Gain on Redemption of Bonds 1,250 Cash 62,500

16 16 Chapter Apple Tree Corp. redeemed one-fourth of the outstanding bonds payable for $90,000 on May 5. The total bonds outstanding had a face amount of $400,000 and an unamortized bond discount of $16,000. Prepare the journal entry to record the redemption. May 5 Bonds Payable 100,000 Gain on Redemption of Bonds 6,000 Discount on Bonds Payable 4,000 Cash 90, On July 15, a corporation redeems one-half of its outstanding bonds payable for $24,000. The total bonds outstanding had a face amount of $50,000 and an unamortized bond discount of $2,200. Prepare the journal entry to record the redemption. July 15 Bonds Payable 25,000 Loss on Redemption of Bonds 100 Discount on Bonds Payable 1,100 Cash 24,000 Strategy: When a bond is redeemed prior to retirement, the unamortized discount or premium related to the bond redeemed also needs to be taken off the books. A discount will be removed with a credit, while a premium will be removed with a debit. Debit Bonds Payable to remove the liability from the books using a debit for the face amount. Credit Cash for the amount paid. Any difference in the cash paid and the bond s carrying amount creates a loss or gain on the redemption. Record losses using a debit and gains using a credit.

17 Liabilities: Bonds Payable A corporation currently has $1,500,000 of 5% bonds outstanding and $5,000,000 of installment notes payable. The company makes semiannual payments of $129,000 on the note ($24,000 of which will be related to interest in the upcoming year). Ignoring any other liabilities, how much of current and long-term liabilities will the corporation s balance sheet present? Current liabilities: Notes payable, current portion $ 105,000 Interest payable 99,000 Total current liabilities $ 204,000 Long-term liabilities: Bonds payable $1,500,000 Notes payable 4,895,000 Total long-term liabilities $6,395,000 Notes payable, current portion: $129,000 $24,000 Interest payable: $24,000 + (5% $1,500,000) Notes payable: $5,000,000 $105,000

18 18 Chapter In addition to the Accounts Payable of $125,000, RPC Corporation has the following liabilities as of December 31: Notes Payable, $750,000 and 10% Bonds Payable, $2,000,000. The company s bonds have an unamortized discount of $134,000, and the notes payable have a payment of $100,000 due in the upcoming January, $21,000 of which will be for interest in the upcoming year. Ignoring any other liabilities the company may have, prepare the liabilities portion of the balance sheet. RPC Corporation Balance Sheet As of December 31 Liabilities Current liabilities: Accounts payable $ 125,000 Notes payable, current portion 79,000 Interest payable 221,000 Total current liabilities $ 425,000 Long-term liabilities: Bonds payable, 10% $2,000,000 Less unamortized discount 134,000 $1,866,000 Notes payable 671,000 Total long-term liabilities $2,537,000 Total liabilities $2,962,000 Notes payable, current portion: $100,000 $21,000 Interest payable: $21,000 + (10% $2,000,000) Notes payable: $750,000 $79,000

19 Liabilities: Bonds Payable Shem Creek Corp. has the following liabilities outstanding: Notes Payable, $6,700,000; 7.5% Bonds Payable, $3,100,000; and Accounts Payable, $150,000. The installment note requires quarterly payments of $41,000 every year, $36,000 of which will be for interest payments for the upcoming year. The bond also has an unamortized premium of $400,000. Ignoring any other liabilities Shem Creek Corp. may have, prepare the liabilities portion of the balance sheet for the calendar year-end. Shem Creek Corp. Balance Sheet As of December 31 Liabilities Current liabilities: Accounts payable $ 150,000 Notes payable, current portion 128,000 Interest payable 268,500 Total current liabilities $ 546,500 Long-term liabilities: Bonds payable, 7.5% $3,100,000 Plus unamortized premium 400,000 $ 3,500,000 Notes payable 6,572,000 Total long-term liabilities $10,072,000 Total liabilities $10,618,500 Notes payable, current portion: ($41,000 4 periods) $36,000 Interest payable: $36,000 + (7.5% $3,100,000) Notes payable: $6,700,000 $128,000 Strategy: Current liabilities include liabilities that will be paid within the upcoming business cycle. Any interest on bonds payable should be recorded as a current liability. Bonds should be recorded as long-term liabilities, unless due within one year, at their carrying amount. Any unamortized premium is reported as an addition to the face amount of the bonds, while any unamortized discount is reported as a deduction from the face amount.

20 20 Chapter Use the information below to determine a corporation s times interest earned ratio for 20Y5 and 20Y6. Round answers to one decimal place. Determine if the change is favorable or unfavorable. 20Y6 20Y5 Interest expense $ 38,750 $ 35,450 Income before income tax expense 326, ,875 Income before income tax expense + Interest expense $365,650 $356,325 Times interest earned ($365,650 $38,750) ($356,325 $35,450) The decrease in times interest earned is unfavorable because the debtholders are less confident they will receive interest payments. 26. Assume the interest on the bonds listed below will be Cooper River Corporation s only interest expense for 20Y5 and 20Y6. Calculate the company s times interest earned ratio for the two years, rounding answers to one decimal place. Determine if the change is favorable or unfavorable. 20Y6 20Y5 10% bonds $1,300,000 $1,200,000 Income before income tax expense 1,025, ,000 Interest expense (Bonds outstanding 10%) 130, ,000 Income before income tax expense + Interest expense $1,155,000 $1,040,000 Times interest earned ($1,155,000 $130,000) ($1,040,000 $120,000) The increase in times interest earned is a favorable trend.

21 Liabilities: Bonds Payable Using the information below, calculate the times interest earned ratio in 20Y5 and 20Y6 for Tortoise Cleaning Corporation. Assume the interest paid on the bond will be the only interest expense for both years, and the company is subject to a 40% tax rate. How many times in each year will the corporation be able to cover its interest payments? Round answers to two decimal places. 20Y6 20Y5 8% bonds $5,270,000 $5,000,000 Net income 525, ,000 Interest expense (Bonds outstanding 8%) 421, ,000 Income before income tax expense [Net income (1 40%)] 875, ,000 Income before income tax expense + Interest expense $1,296,600 $1,150,000 Times interest earned ($1,296,600 $875,000) ($1,150,000 $750,000) In 20Y5, the corporation earned enough income to pay its interest expense 2.9 times. The number of times it could pay interest increased to 3.1 in 20Y6. Strategy: To find the times interest earned ratio, first determine the income before income tax expense and interest expense. Add the two and divide the sum by the interest expense. Investors prefer a higher ratio because it indicates the company has a higher ability to pay its interest.

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