Question

The following amortization and interest schedule reflects the issuance of 10-year bonds by Capulet Corporation on January 1, 2011, and the subsequent interest payments and charges. The company’s year-end is December 31, and financial statements are prepared once yearly.

Amortization Schedule
Year	Cash	Interest	Amount unamortized	Carrying value
1/1/2011			\(5,651	\)94,349
2011	\(11,000	\)11,322	5,329	94,671
2012	11,000	11,361	4,968	95,032
2013	11,000	11,404	4,564	95,436
2014	11,000	11,452	4,112	95,888
2015	11,000	11,507	3,605	95,395
2016	11,000	11,567	3,038	96,962
2017	11,000	11,635	2,403	97,597
2018	11,000	11,712	1,691	98,309
2019	11,000	11,797	894	99,106
2020	11,000	11,894		100,000

Instructions

(a) Indicate whether the bonds were issued at a premium or a discount and how you can determine this fact from the schedule.

(b) Indicate whether the amortization schedule is based on the straight-line method or the effective-interest method, and how you can determine which method is used.

(c) Determine the stated interest rate and the effective-interest rate.

(d) On the basis of the schedule above, prepare the journal entry to record the issuance of the bonds on January 1, 2011.

(e) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transactions and accruals for 2011. (Interest is paid on January 1.)

(f) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transactions and accruals for 2018. Capulet Corporation does not use reversing entries.

Short answer

1. Bonds are issued at a discount.
2. Effective interest method is used to amortize the discount.
3. Stated interest rate:11% and effective interest rate:12%.
4. Journal entry for issuance includes debit for cash, debit for a discount on bond payable, and credit for bond payable.
5. Journal entry for 2011 includes the accrual of interest and amortization of discount because the first payment will be made in 2012.
6. Journal entry for 2018 will include payment of interest for 2017, accrual of interest for 2018, and bond amortization for 2018.

Step-by-step solution

Definition of Interest Payable

Interest payable can be defined as the interest expenses incurred by the business entity but not paid to the creditor. These are reported under current liabilities by the business entity.

Bonds issued at discount or premium

The bonds are issued at a discount of $5,651 because the maturity value in 2020 is $100,000, which is higher than the carrying value at issuing date.

Method used to amortize the bonds

The business entity uses the effective interest method to amortize bonds discount because the interest rate increasing each year will give a different amortization value each year, and the amortization value remains the same under the straight-line method

Interest rates

Calculation of stated interest rate:

$\begin{array}{rcl}\mathit{S}\mathit{t}\mathit{a}\mathit{t}\mathit{e}\mathit{d}\mathit{i}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathit{r}\mathit{a}\mathit{t}\mathit{e}& \mathbf{=}& \frac{\mathbf{C}\mathbf{a}\mathbf{s}\mathbf{h}\mathbf{p}\mathbf{a}\mathbf{i}\mathbf{d}\mathbf{i}\mathbf{n}\mathbf{2011}}{\mathbf{C}\mathbf{a}\mathbf{r}\mathbf{r}\mathbf{y}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{v}\mathbf{a}\mathbf{l}\mathbf{u}\mathbf{e}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{s}\mathbf{s}\mathbf{u}\mathbf{e}\mathbf{d}\mathbf{a}\mathbf{t}\mathbf{e}\mathbf{+}\mathbf{U}\mathbf{n}\mathbf{a}\mathbf{m}\mathbf{o}\mathbf{r}\mathbf{t}\mathbf{i}\mathbf{z}\mathbf{e}\mathbf{d}\mathbf{d}\mathbf{i}\mathbf{s}\mathbf{c}\mathbf{o}\mathbf{u}\mathbf{n}\mathbf{t}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{s}\mathbf{s}\mathbf{u}\mathbf{e}\mathbf{d}\mathbf{a}\mathbf{t}\mathbf{e}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{11}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{94}\mathbf{,}\mathbf{349}\mathbf{+}\mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{651}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{11}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{100}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{11}\mathbf{\%}\\ & & \end{array}$

Calculation of effective interest rate:

$\begin{array}{rcl}\mathit{E}\mathit{f}\mathit{f}\mathit{e}\mathit{c}\mathit{t}\mathit{i}\mathit{v}\mathit{e}\mathit{i}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathit{r}\mathit{a}\mathit{t}\mathit{e}& \mathbf{=}& \frac{\mathbf{I}\mathbf{n}\mathbf{t}\mathbf{e}\mathbf{r}\mathbf{e}\mathbf{s}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{2011}}{\mathbf{C}\mathbf{a}\mathbf{r}\mathbf{r}\mathbf{y}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{v}\mathbf{a}\mathbf{l}\mathbf{u}\mathbf{e}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{s}\mathbf{s}\mathbf{u}\mathbf{e}\mathbf{d}\mathbf{a}\mathbf{t}\mathbf{e}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{11}\mathbf{,}\mathbf{322}}{\mathbf{\$}\mathbf{94}\mathbf{,}\mathbf{349}}\\ & \mathbf{=}& \mathbf{12}\mathbf{\%}\\ & & \end{array}$

Journal entries for issuance

Date	Accounts and Explanation	Debit ($)	Credit ($)
1 Jan 2011	Cash	94,349
	Discount on bonds payable	5,651
	Bonds payable		100,000

Journal entries for 2011 accrual and bonds transactions

Date	Accounts and Explanation	Debit ($)	Credit ($)
31 Dec 2011	Interest expenses	11,322
	Discount on bond payable		322
	Interest payable		11,000

Journal entries for 2018 accrual and bonds transactions

Date	Accounts and Explanation	Debit ($)	Credit ($)
1 Jan 2018	Interest Payable	11,000
	Cash		11,000
31 Dec 2018	Interest expenses	11,712
	Discount on bond payable		712
	Interest payable		11,000