Question

(Entries and Questions for Bond Transactions) On June 30, 2017, Mischa Auer Company issued \(4,000,000 face value of 13%, 20-year bonds at \)4,300,920, a yield of 12%. Auer uses the effective-interest method to amortize bond premium or discount. The bonds pay semi-annual interest on June 30 and -December 31.

Instructions

(Round answers to the nearest cent.)

(a) Prepare the journal entries to record the following transactions.

(1) The issuance of the bonds on June 30, 2017.

(2) The payment of interest and the amortization of the premium on December 31, 2017.

(3) The payment of interest and the amortization of the premium on June 30, 2018.

(4) The payment of interest and the amortization of the premium on December 31, 2018.

(b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31, 2018, balance sheet.

(c) Provide the answers to the following questions.

(1) What amount of interest expense is reported for 2018?

(2) Will the bond interest expense reported in 2018 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used?

(3) Determine the total cost of borrowing over the life of the bond.

(4) Will the total bond interest expense for the life of the bond be greater than, the same as, or less than the total interest expense if the straight-line method of amortization were used?

Short answer

(a) Both sides of the journal totals $5,080,920.

(b) Bond payable on the balance sheet of December 31, 2018,is$4,294,728.542.

(c) Interest expenses under the straight-line method will be lower for the year 2018.

(d) Total interest expenses reported under both methods will be the same.

Step-by-step solution

Definition of Interest Payable

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

Journal entries

Date	Accounts and Explanation	Debit $	Credit $
30 June 2017	Cash	$4,300,920
	Premium on bond payable		$300,920
	Bond payable		$4,000,000
31 Dec 2017	Interest expenses	$258,055
	Premium on bond payable	$1,945
	Cash		$260,000
30 June 2018	Interest expenses	$257,939
	Premium on bond payable	$2,061
	Cash		$260,000
31 Dec 2018	Interest expenses	$257,815
	Premium on bond payable	$2,185
	Cash		$260,000
		$5,080,920	$5,080,920

Working note: Bonds amortization schedule

Date	Interest payment at the stated rate on face value (6.5%)	Interest expenses at the market rate on the previous year book value (6%)	Amortized premium	Unamortized premium	Bond payable	Book value of bond payable
30 June 2017				$300,920	$4,000,000	$4,300,920
31 Dec 2017	$260,000	$258,055.2	$1,944.8	$298,975.2	$4,000,000	$4,298,975.2
30 June 2018	$260,000	$257,938.512	$2,061.488	$296,913.712	$4,000,000	$4,296,913.712
31 Dec 2018	$260,000	$257,814.823	$2,185.17	$294,728.542	$4,000,000	$4,294,728.542

Balance sheet

Particular	Amount $
Bond payable	$4,000,000
Add: Premium on bond payable	$294,728.542
Bond payable	$4,294,728.542

Reporting various line items

(1) Interest expenses reported for the year 2018:

Particular	Amount $
30 June 2018	$257,938.512
31 Dec 2018	257,814.823
Total interest expenses for the year 2018	$515,753.344

(2) Comparison between the straight-line amortization and the effective interest method:

Interest expenses for the year 2018 will be lower if the business entity uses the straight-line method for the amortization of bond premium.

Working note:

Calculation of interest expenses under the straight-line method:

Particular	Amount $
Cash paid @6.5% of $4,000,000	$260,000
Less: Premium amortization$\left(\frac{\$300,920}{40}\right)$	(7,523)
Interest expenses	$252,477
Interest expenses for 2018	$504,954

(3) Total cost of borrowing over the life of the bond:

$\begin{array}{c}Totalcostofborrowing=Interestpaymentatstatedrateeachperiod\times Numberofperiods\\ =\$260,000\times 40\\ =\$10,400,000\end{array}$

Comparison of total bond interest expenses of effective interest method and straight-line method: Total interest expenses over the life of the will remains

the same under both methods i.e., straight-line method and effective interest method.