Question

On March 1, 2017, Sealy Company sold its 5-year, $1,000 face value, 9% bonds dated March 1, 2017, at an effective annual interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2017. Sealy uses the effective-interest method of amortization. The bonds can be called by Sealy at 101 at any time on or after March 1, 2018.

Instructions

a. (1) How would the selling price of the bond be determined?

(2) Specify how all items related to the bonds would be presented in a balance sheet prepared immediately after the bond issue was sold.

b. What items related to the bond issue would be included in Sealy’s 2017 income statement, and how would each be determined?

c. Would the amount of bond discount amortization using the effective-interest method of amortization be lower in the second or third year of the life of the bond issue? Why?

d. Assuming that the bonds were called in and redeemed on March 1, 2018, how should Sealy report the redemption of the bonds on the 2018 income statement?

Short answer

1. The selling price of the bonds would be the present value of all the expected net future cash outflows discounted atthe effectiveannual interest rate (yield) of 11 percent.
2. The bond discount should be amortized using the effective-interest method over the period the bonds will be outstanding.
3. The amount of bond discount amortization would be lower in the second year.
4. The retirement of the bonds should be classified as an ordinary loss.

Step-by-step solution

Meaning of Bond

Bonds are tradable assets that are securitized versions of the corporatedebt that the company issue. Bonds are fixed-income instruments since they verifiably pay debt holders a fixed interest rate(coupon).

(a) Explain the determination of the bond's selling price and presentation of the bond on the balance sheet

1. The present value of all anticipated net future cash outflows, discounted at an effective yearly interest rate (yield) of 11%, would be the selling price of the bonds. The present value is calculated as the sum of the maturity amount's (face value) present value and the sequence of subsequent semi-annual interest payments' present values.

Calculation of selling price of the bond

Present value of the principal (Table 6-2) $\left(\$1,000\times 0.59345\right)$discounted at 11%	$593.45
Present value of the interest payments (Table 6-4) $\left(\$45\times 5.8892\right)$discounted at 11%	$265.014
Present value(Selling price) of the bonds	858.464

Working note:

$\begin{array}{rcl}Interest on semi-annual bond& =& \$1,000\times \frac{9}{100}\times \frac{6}{12}\\ & =& \$45\\ & & \end{array}$

2. The proceeds from the sale of the bond issue would enhance the current asset, cash, immediately after the bond issue is sold. Bonds payable would be shown as a noncurrent debt on the balance sheet at the face value of the bonds less the discount. Under generally accepted accounting principles, the bond issue expenses would be categorized as a "noncurrent asset, deferred charge." However, there is theoretical support for classifying the bond issue costs as either an expense or a decrease of the associated debt liability.

(b) Explaining the items related to the bond issue would be included in Sealy’s 2017 income statement and how it’s determined.

Ten months (from March 1, 2017, to December 31, 2017), with an effective interest rate (yield) of 11%, would be covered by interest expenses. It is made up of nominal interest at 9 percent that has been prorated to account for bond discount amortization. The bond discount should be amortized during the period the bonds will be outstanding, or from the date of sale (March 1, 2017) until the maturity date, using the effective-interest method (March 1, 2022)

(c) Explaining the amount of bond discount amortization

In the second year of the bond issue's existence, the amount of bond discount amortization would be smaller. The effective-interest method of amortization uses a constant interest rate based on a fluctuating carrying value, which causes the amortization to increase each year when a bond markdown occurs.

(d) Explain the reporting of the redemption of the bond on the income statement.

Retirement of the bonds would cause a loss from extinguishing debt, which should be considered when calculating net income and designated as an ordinary loss.