Chapter 14, Problem 14.7P

(1)

To determine

Bonds

Bonds are a kind of interest bearing notes payable, usually issued by companies, universities and governmental organizations. It is a debt instrument used for the purpose of raising fund of the corporations or governmental agencies. If selling price of the bond is equal to its face value, it is called as par on bond. If selling price of the bond is lesser than the face value, it is known as discount on bond. If selling price of the bond is greater than the face value, it is known as premium on bond.

Effective interest rate of amortization bond

Effective interest rate method of amortization is a process of amortizing premium on bond or discount on bond, which allocates the different amount of interest expense in each period of interest payment, but at a constant percentage rate.

To Determine: The price of the bonds for Instruments M as on 1^st January 2016.

Explanation of Solution

Calculate price of the bonds as on 1^st January 2016.

$\begin{array}{c}\text{Price of bonds}\}=\left\{\begin{array}{l}\text{Present value of principal}+\\ \text{Present value of interest payments}\end{array}\right\}\\ =\$56,820,000+\$274,545,440\\ =\$331,365,440\end{array}$

Therefore, price of the bonds as on 1^st January 2016 is $33,365,440.

Working notes:

Calculate present value of the principal amount.

Particulars	Amount ($)
Face value of bonds (a)	$400,000,000
PV factor at an annual market rate of 5% for 40 periods (b)	$\times$ 0.14205
Present value of face value of the bonds $\left(\text{a}\right)\text{×}\left(\text{b}\right)$	$56,820,000

Table (1)

Note: The present value of $1 for 40 periods at 5% is 0.14205 (refer Table 2 in Appendix).

Hence, present value of the principal amount is $56,820,000.

Calculate present value of the interest payment.

Particulars	Amount ($)
Interest payments amount (a)	$16,000,000
PV factor at an annual market rate of 5% for 40 periods (b)	$\times$17.15909
Present value of interest payments $\left(\text{a}\right)\text{×}\left(\text{b}\right)$	$274,545,440

Note: The Present value of an ordinary annuity of $1 for 40 periods at 5% is 17.15909 (refer Table 4 in Appendix).

Table (2)

Hence, present value of the interest payment amount is $274,545,440.

Calculate interest payment amount.

$\begin{array}{c}\text{Interest payment}=\text{Face value of bonds}\times \text{ interest rate}\\ =\$400,000,000\times \frac{4}{100}\\ =\$16,000,000\end{array}$

Hence, interest payment amount is $16,000,000.

Price of the bonds is calculated by adding present value of the principal amount and present value of the interest payments. Therefore, price of the bonds as on 1^st January 2018 is $33,365,440.

(2) (a)

To determine

To Prepare: The journal entries to record the issuance of the bonds by Instruments M.

Explanation of Solution

Prepare the journal entry to record the issuance of the bonds by instruments M as on 1^st January 2016.

The following is the journal entry for issuance of bonds

Date		Account Title and Explanation	Debit ($)	Credit ($)
2016		Cash	331,365,440
January	1
		Discount on Bonds Payable	68,634,560
		Bonds Payable		400,000,000
		(To record the issuance of bonds)

Table (3)

Working note:

Calculate discount on bonds payable.

$\begin{array}{c}\text{Discount on bonds payable }=\text{Bonds payable –}\text{Cash received}\\ =\$400,000,000-\$331,365,440\\ =\$68,634,560\end{array}$

Hence, discount on bonds payable amount is $68,634,560.

• Cash is an asset and it increases by $331,365,440. Therefore, debit cash account by $331,365,440.
• Discount on bonds payable is a contra liability and it decreases by $68,634,560. Therefore, debit discount on bonds payable account by $68,634,560.
• Bonds payable is a long-term liability and it increases by $400,000,000. Therefore, credit bonds payable account by $400,000,000.

2 (b)

To determine

To Prepare: The journal entry to record B’s investment on January 1, 2016.

Explanation of Solution

Prepare the journal entry for purchases of bonds on January 1, 2016.

Date		Account Title and Explanation	Debit ($)	Credit ($)
2016		Bonds Investment	400,000
January	1
		Discount on Bonds Investment		68,635
		Cash		331,365
		(To record the purchase of  bonds)

Table (2)

Working notes:

Calculate the cash paid for investment.

$\begin{array}{c}\text{Cash paid = \$331,365,440}\times 0.1\text{\%}\\ \text{= \$331,365}\end{array}$

Hence, cash paid amount is $331,365.

Calculate discount on bonds investment.

$\begin{array}{c}\text{Discount on bonds investment }=\text{Bonds investment –}\text{Cash paid}\\ =\$400,000-\$331,365\\ =\$68,635\end{array}$

Hence, discount on bonds investment amount is $68,635.

• Bonds investment is an assets and it increases by $400,000. Therefore, debit bonds investment account by $400,000.
• Discount on bonds investment is a contra liability and it increases by $68,635. Therefore, credit discount on bonds investment account by $68,635.
• Cash is an asset and it increases by $331,365. Therefore, debit cash account by $331,365.

(3) (a)

To determine

To Prepare: The journal entry to record interest on June 30, 2016 of Instruments M.

Explanation of Solution

Prepare the journal entry for payment of semiannual interest and amortization of discount on bonds.

Date		Account Title and Explanation			Debit ($)	Credit ($)
2016		Interest Expense			16,568,272
June	30		Discount on Bonds Payable			568,272
			Cash			16,000,000
				(To record payment of semi-annual interest)

Table (3)

• Interest Expense is an expense and it decreases the value of equity. Therefore, debit interest expense account by $16,568,272.
• Discount on bonds payable is a contra liability and it increases by $568,272. Therefore, credit discount on bonds payable account by $568,272.
• Cash is an asset and it decreases by $16,000,000. Therefore, credit cash account by $16,000,000.

Working notes:

Calculate the amount of interest as on June 30, 2016.

$\begin{array}{c}\text{Interest payable}\left(\text{Cash}\text{paid}\right)=\left(\begin{array}{l}\text{Face value}\times \text{Stated interest rate}\\ \times \text{Interest time period}\end{array}\right)\\ =\$400,000,000\times 8\%\times \frac{6}{12}\\ =\$16,000,000\end{array}$

Hence, interest payable amount is $16,000,000.

Calculate the interest expense on the bond as on June 30, 2016.

$\begin{array}{c}\text{Interest expense}=\text{Price of bonds}\times \text{Market interest rate}\times \text{Interest time period}\\ =\$331,365,440\times 10\%\times \frac{6}{12}\\ =\$16,568,272\end{array}$

Hence, interest expense amount is $16,568,272.

Calculate discount on bonds payable.

$\begin{array}{c}\text{Discount on bonds payable }=\text{Interest expense –}\text{Cash paid}\\ =\$16,568,272-\$16,000,000\\ =\$568,272\end{array}$

Hence, discount on bonds payable amount is $568,272.

3 (b)

To determine

To Prepare: The journal entry to record interest revenue on June 30, 2016 of Incorporation BT.

Explanation of Solution

Prepare the journal entry for semiannual interest revenue on June 30, 2018.

Date		Account Title and Explanation			Debit ($)	Credit ($)
2016		Cash			16,000
June	30	Discount on Bonds Investment			568
			Interest Revenue			16,568
				(To record semi-annual interest revenue)

Table (4)

Working notes:

Calculate the amount of interest receivable as on June 30, 2016.

$\begin{array}{c}\text{Interest receivable}\left(\text{Cash}\text{received}\right)=\left(\begin{array}{l}\text{Face value}\times \text{Stated interest rate}\\ \times \text{Interest time period}\end{array}\right)\\ =\$400,000\times 8\%\times \frac{6}{12}\\ =\$16,000\end{array}$

Hence, interest receivable amount is $16,000.

Calculate the interest revenue on the bond as on June 30, 2016.

$\begin{array}{c}\text{Interest}\text{revenue}=5\%\times \$331,365\\ =\$16,568\end{array}$

Hence, interest revenue amount is $16,568.

Calculate discount on bonds investment.

$\begin{array}{c}\text{Discount of bond investment }=\text{Interest}\text{revenue}–\text{Cash}\text{received}\\ =\$16,568-\$16,000\\ =\$568\end{array}$

Hence, discount on bond investment is $568.

• Cash is an asset and it increases by $16,000. Therefore, debit cash account by $16,000.
• Discount on bonds investment is a contra liability and it decreases by $568. Therefore, debit discount on bonds investment account by $568.
• Interest revenue is revenue and it increases the value of equity. Therefore, credit interest revenue account by $16,568.

(4) (a)

To determine

To Prepare: The journal entry to record interest on December 31, 2016.

Explanation of Solution

Prepare the journal entry for payment of semiannual interest and amortization of discount on bonds on December 31, 2016.

Date		Account Title and Explanation			Debit ($)	Credit ($)
2016		Interest Expense			16,596,686
December	31		Discount on Bonds Payable			596,686
			Cash			16,000,000
				(To record payment of semi-annual interest)

Table (5)

Working notes:

Calculate the amount of interest as on December 31, 2016.

$\begin{array}{c}\text{Interest payable}\left(\text{Cash}\text{paid}\right)=\left(\begin{array}{l}\text{Face value}\times \text{Stated interest rate}\\ \times \text{Interest time period}\end{array}\right)\\ =\$400,000,000\times 8\%\times \frac{6}{12}\\ =\$16,000,000\end{array}$

Calculate the interest expense on the bond as on December 31, 2016.

$\begin{array}{c}\text{Interest expense}=\text{Price of bonds}\times \text{Market interest rate}\times \text{Interest time period}\\ =\left(\$331,365,440+\$568,272\right)\times 10\%\times \frac{6}{12}\\ =\$16,596,686\end{array}$

Calculate discount on bonds payable.

$\begin{array}{c}\text{Discount on bonds payable }=\text{Interest expense –}\text{Cash paid}\\ =\$16,596,686-\$16,000,000\\ =\$596,686\end{array}$

• Interest Expense is an expense and it decreases the value of equity. Therefore, debit interest expense account by $16,596,686.
• Discount on bonds payable is a contra liability and it increases by $596,686. Therefore, credit discount on bonds payable account by $596,686.
• Cash is an asset and it decreases by $16,000,000. Therefore, credit cash account by $16,000,000.

4 (b)

To determine

To Prepare the journal entry to record interest revenue on December 31, 2016 of Incorporation B.

Explanation of Solution

Prepare the journal entry for semiannual interest revenue on December 31, 2016.

Date		Account Title and Explanation			Debit ($)	Credit ($)
2016		Cash			16,000
December	31	Discount on Bonds Investment			597
			Interest Revenue			16,597
				(To record semi-annual interest revenue)

Table (6)

Working notes:

Calculate the amount of interest receivable as on December 31, 2016.

$\begin{array}{c}\text{Interest receivable}\left(\text{Cash}\text{received}\right)=\left(\begin{array}{l}\text{Face value}\times \text{Stated interest rate}\\ \times \text{Interest time period}\end{array}\right)\\ =\$400,000\times 8\%\times \frac{6}{12}\\ =\$16,000\end{array}$

Hence, interest receivable amount is $16,000.

Calculate the interest revenue on the bond as on December 31, 2016.

$\begin{array}{c}\text{Interest}\text{revenue}=5\%\times \left(\$331,365+\$568\right)\\ =\$16,597\end{array}$

Hence, interest revenue amount is $16,597.

Calculate discount on bonds investment.

$\begin{array}{c}\text{Discount of bond investment }=\text{Interest}\text{revenue}–\text{Cash}\text{received}\\ =\$16,597-\$16,000\\ =\$597\end{array}$

Hence, discount on bond investment amount is $597.

• Cash is an asset and it increases by $16,000. Therefore, debit cash account by $16,000.
• Discount on bonds investment is a contra liability and it decreases by $597. Therefore, debit discount on bonds investment account by $597.
• Interest revenue is revenue and it increases the value of equity. Therefore, credit interest revenue account by $16,597.