ACCT 2301 HW 8 Solutions

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University of Texas, Dallas *

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2301

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Accounting

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Feb 20, 2024

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ACCT 2301 - Homework 8 - Solutions 1. Explain what a bond is. A bond is a financial instrument that allows a company to borrow money in exchange for (i) the obligation to reimburse the money at maturity, and (ii) the obligation to pay for periodic interests. 2. Explain what (a) par value, (b) maturity, (c) nominal rate, (d) market rate, and (e) the price of a bond are. Par Value : the nominal amount of money the company will need to reimburse at maturity. Maturity : the future date on which the company will need to reimburse the borrowed money. Nominal Rate : the interest rate used to determine periodic interest payments. Market Rate : the interest rate offered by similar securities in the debt market. It is used to discount the future bond’s cash flows and determine its price. Price : the current fair price of the bond based on the present value of the sum of future discounted cash flows generated by the bond. The price is what the company receives (i.e., its financing) when selling the bond. 3. Explain how are bonds measured within the accounting system. Bonds are measured at their current cash equivalent. Measuring the current cash equivalent requires computing the present value of the sum of future cash flows generated by the bond. To compute such a present value, one needs to use the nominal rate to determine the interest payments, and then the market rate to discount those cash flows (including the reimbursement of the par or principal amount). 4. The fair value of a bond is the sum of its future discounted cash flows. a. True b. False 5. If the market rate is above the nominal rate the bond is sold at a premium. a. True b. False 6. Explain what premiums and discounts on bonds are and what generates them. Homework 8 - Solutions Page 1 of 4

Premiums are generated when the nominal rate of a bond exceeds the market rate (i.e., the bond is offering more than market; therefore, investors are willing to pay for a premium). Discounts are generated when the nominal rate of a bond is below the market rate (i.e., the bond is offering less than market; therefore, investors require a price discount to be willing to buy the bond). 7. Premiums are amortized, but discounts are not amortized. a. True b. False 8. Company “Z” on 1/1/2020 issues a 20% bond with face value of $800,000 that will mature in 5 years. Interests are paid semi-annually on 6/30 and 12/31. Calculate the price of the bond and record all the accounting journal entries for 2020, assuming that the market rate is 20% Calculate the price of the bond and record all the accounting journal entries for 2020, assuming that the market rate is 10% Calculate the price of the bond and record all the accounting journal entries for 2020, assuming that the market rate is 25% Note: for this exercise, you will need to record the transactions associated with the bond issuance and the payment of semi-annual interests. If it takes you less than 15 minutes to solve this problem, you are probably missing something. Case 1 : market rate = 20% Price = Par/Face Value = $800,000 Interest Expense: $80,000 On 1/1/2020 Cash (A+), Debit, $800,000 Bond Payable (L+), Credit, $800,000 On 6/30/2020 Interest Expense (Exp+), Debit, $80,000 Cash (A-), Credit, $80,000 On 12/31/2020 Interest Expense (Exp+), Debit, $80,000 Cash (A-), Credit, $80,000 Homework 8 - Solutions Page 2 of 4

Case 2 : market rate = 10% Price ¿ ∑ t = 1 10 80,000 ( 1 +( 0.1 2 )) t + 800,000 ( 1 +( 0.1 2 )) 10 = $1,108,869 Interest Expense = 1,108,869 * 10%/2 = $55,444 On 1/1/2020 Cash (A+), Debit, $1,108,869 Bond Premium (L+), Credit, 308,869 Bond Payable (L+), Credit, $800,000 On 6/30/2020 Interest Expense (Exp+), Debit, $55,444 Bond Premium (L-), Debit, $24,557 Cash (A-), Credit, $80,000 On 12/31/2020 Interest Expense (Exp+), Debit, $55,444 Bond Premium (L-), Debit, $24,557 Cash (A-), Credit, $80,000 Case 3 : market rate = 25% Price ¿ ∑ t = 1 10 80,000 ( 1 +( 0.25 2 )) t + 800,000 ( 1 +( 0.25 2 )) 10 = $689,271 Interest expense = 689,271 * 25%/2 = $86,159 On 1/1/2020 Cash (A+), Debit, $689,271 Bond Discount (XL+), Debit, 110,729 Bond Payable (L+), Credit, $800,000 On 6/30/2020 Interest Expense (Exp+), Debit, $86,159 Bond Discount(XL-), Credit, $6,159 Cash (A-), Credit, $80,000 On 12/31/2020 Homework 8 - Solutions Page 3 of 4

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