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Chapter 14: Q.14-11FRS (page 772)

Question: What is the required method of amortizing discount and premium on bonds payable? Explain the procedures.

Short Answer

Expert verified

Answer

The required method of amortizing discount and premium on bonds payable is effective interest and the straight-line method.

The effective interest method is a method for evaluating the existing rate of interest in a period. The straight-line method is a method of estimating amortization as well as depreciation.

Step by step solution

01

Meaning of Bonds Payable

Bonds payable is defined as an accounting obligation that consists of the value that the issuer has to pay to the bondholders. It is usually reflected within the long-term liabilities portion of the balance sheet, as bonds usually mature after a year.

02

Effective interest method

The effective interest method is a procedure for estimating the real rate of interest in a period dependent on the value of an accounting instrument’s carrying amount at the initial phase of the financial period. If the carrying amount of an accounting instrument decreases, then the value of the interest associated with it will also decrease. A bond premium takes place when the investors want to pay higher than the book value of the bond, as its coupon interest rate is higher than the existing current interest rate. Whereas a bond discount occurs when investors want to pay lower than the par value of the bond, as its coupon interest rate is less than the existing market rate.

03

Straight-line method

In a straight-line method, a discount on a bond or premium is charged uniformly in each period of the life of the bond. When the conversion rate on a bond is less than the current interest rate, the bond is issued at a discount to face value. However, if the conversion rate is more than the current interest rate, the bond is issued at a premium to its face value. In the case of a bond issued on discount, the book value is equivalent to par value minus the discount on the bond, whereas, in the case of the issue on premium, the book value is the equivalent face value plus unamortized premium.

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Most popular questions from this chapter

Teton Corporation issued \(600,000 of 7% bonds on November 1, 2017, for \)644,636. The bonds were dated November 1, 2017, and mature in 10 years, with interest payable each May 1 and November 1. Teton uses the effective-interest method with an effective rate of 6%. Prepare Teton’s December 31, 2017, adjusting entry.

Under what conditions of bond issuance do a discount on bonds payable arise? Under what conditions of bond issuance does a premium on bonds payable arise?

Question: The following information is taken from the 2017 annual report of Bugant, Inc. Bugant’s fiscal year ends December 31 of each year. Bugant’s December 31, 2017, balance sheet is as follows.

Bugant, Inc.

Balance Sheet

December 31, 2017

Assets

Cash \( 450

Inventory 1,800

Total current assets 2,250

Plant and equipment 2,000

Accumulated depreciation (160)

Total assets \)4,090

Liabilities

Bonds payable (net of discount) \(1,426

Stockholders’ equity

Common stock 1,500

Retained earnings 1,164

Total liabilities and stockholders’ equity \)4,090

Note X: Long Term Debt:

On January 1, 2016, Bugant issued bonds with face value of \(1,500 and a coupon rate equal to 10%. The bonds were issued to yield 12% and mature on January 1, 2021.

Additional information concerning 2018 is as follows.

  1. Sales were \)3,500, all for cash.
  2. Purchases were \(2,000, all paid in cash.
  3. Salaries were \)700, all paid in cash.
  4. Property, plant, and equipment was originally purchased for \(2,000 and is depreciated straight-line over a 25-year life with no salvage value.
  5. Ending inventory was \)1,900.
  6. Cash dividends of \(100 were declared and paid by Bugant.
  7. Ignore taxes.
  8. The market rate of interest on bonds of similar risk was 12% during all of 2018.
  9. Interest on the bonds is paid semiannually each June 30 and December 31.

Accounting

Prepare a balance sheet for Bugant, Inc. at December 31, 2018, and an income statement for the year ending December 31, 2018. Assume semiannual compounding of the bond interest.

Analysis

Use common ratios for analysis of long-term debt to assess Bugant’s long-run solvency. Has Bugant’s solvency changed much from 2017 to 2018? Bugant’s net income in 2017 was \)550 and interest expense was $169.

Principles

The FASB and the IASB allow companies the option of recognizing in their financial statements the fair values of their long-term debt. That is, companies have the option to change the balance sheet value of their long-term debt to the debt’s fair value and report the change in balance sheet value as a gain or loss in income. In terms of the qualitative characteristics of accounting information (Chapter 2), briefly describe the potential trade-off(s) involved in reporting long-term debt at its fair value.

Presented below are two independent situations.

(a) On January 1, 2017, Robin Wright Inc. purchased land that had an assessed value of \(350,000 at the time of purchase. A \)550,000, zero-interest-bearing note due January 1, 2020, was given in exchange. There was no established exchange price for the land, nor a ready fair value for the note. The interest rate charged on a note of this type is 12%. Determine at what amount the land should be recorded at January 1, 2017, and the interest expense to be reported in 2017 related to this transaction.

(b) On January 1, 2017, Field Furniture Co. borrowed $5,000,000 (face value) from Gary Sinise Co., a major customer, through a zero-interest-bearing note due in 4 years. Because the note was zero-interest-bearing, Field Furniture agreed to sell furniture to this customer at lower than market price. A 10% rate of interest is normally charged on this type of loan. Prepare the journal entry to record this transaction and determine the amount of interest expense to report for 2017.

What disclosures are required relative to long-term debt and sinking fund requirements?
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