Logout Open In App
Open In App
Warning: foreach() argument must be of type array|object, bool given in /var/www/html/web/app/themes/studypress-core-theme/template-parts/header/mobile-offcanvas.php on line 20

Chapter 14: Question 3Q (page 752)

Distinguish between the following interest rates for bonds payable:

(a)Yield rate

(b) Nominal Rate

(c) Stated rate

(d) Market rate

(e) Effective rate

Short Answer

Expert verified

The yield rate is the rate actually earned by the bondholders. The nominal rate is the rate fixed by the one who issues the bonds, usually expressed as a percentage on par value. The stated rate is the specified rate listed on the bond. The market rate is the current rate prevailing in the market depending on various factors. The effective rateis the true rate on the bond, which takes into account the effects of compounding.

Step by step solution

01

Meaning of Bonds Payable

Bonds payable is a liability that arises when a company issues bonds to generate cash. The company is a borrower, thus creating a liability. Bonds can be issued at par, discount, and at a premium. The pricing depends on the difference between its coupon rate and its market yield.

02

(a) Yield rate

  • Yield rate is the rate of return the bond generates. It can say what percent was made from an investment.
  • A company can use this rate to compare various projects or investments to decide which is most profitable.
  • Current Yield = Annual cash/ Bond price
03

(b) Nominal rate

  • Nominal rate is the rate bond issuer promises to pay the bond purchaser.
  • The rate is fixed, expressed as a percentage on par value, and is applied to the lifetime of the bond.
  • It is the actual interest rate stated without considering the effect of compounding.
  • Nominal rate = Annual Interest payment/ Face value
04

(c) Stated rate

  • Stated rate is the actual rate listed on the bond
  • It is the actual amount of interest paid by the bond issuer, similar to the nominal rate.
  • Example, if an issuer pays $60 on a bond with the face value of $1000, then the stated interest rate is 6%.
  • Stated rate = Bond payment/ Face value
05

(d) Market rate

  • Market rate is the prevailing rate offered on cash deposits.
  • It is determined by the current rate compared to the rate specified in the bond.
  • It considers two things: The present value of the bond`s face value & Present value of the bond`s interest payments.
  • This rate is driven by many factors such as the size and duration of deposits, the flow of funds in & out of the country, etc.
  • Market rate = Bond`s face value * Bond`s price quote
06

(e) Effective rate

  • Effective rate is the rate that will discount both the bond`s future. interest payments and the bond`s maturity value to a present value that is equal to the bond`s current market value.
  • It is similar to market and yield rate, but it takes into account the effects of compounding.
  • The more frequent the compounding period, the higher the rate.
  • Effective rate = [ 1 + i/n ] n - 1

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

What is the fair value option? Briefly describe the controversy of applying the fair value option to financial liabilities.

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.

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.

On January 1, 2017, Ellen Carter Company makes the two following acquisitions.

  1. Purchases land having a fair value of \(200,000 by issuing a 5-year, zero-interest-bearing promissory note in the face amount of \)337,012.
  2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of $250,000 (interest payable annually).

The company has to pay 11% interest for funds from its bank

Instructions

(Round answers to the nearest cent.)

  1. Record the two journal entries that should be recorded by Ellen Carter Company for the two purchases on January 1, 2017.
  2. Record the interest at the end of the first year on both notes using the effective-interest method.

Fallen Company commonly issues long-term notes payable to its various lenders. Fallen has had a pretty good credit rating such that its effective borrowing rate is quite low (less than 8% on an annual basis). Fallen has elected to use the fair value option for the long-term notes issued to Barclay’s Bank and has the following data related to the carrying and fair value for these notes. Any changes in fair value are due to changes in market rates, not credit risk.

Carrying Value

Fair Value

December 31, 2017

\(54,000

\)54,000

December 31, 2018

44,000

42,500

December 31, 2019

36,000

38,000

Instructions

(a) Prepare the journal entry at December 31 (Fallen’s year-end) for 2017, 2018, and 2019, to record the fair value option for these notes.

(b) At what amount will the note be reported on Fallen’s 2018 balance sheet?

(c) What is the effect of recording the fair value option on these notes on Fallen’s 2019 income?

(d) Assuming that general market interest rates have been stable over the period, does the fair value data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2019? Explain.
See all solutions

Recommended explanations on Business Studies Textbooks

Startups

Read Explanation

Corporate Finance

Read Explanation

Managerial Economics

Read Explanation

Sales in Business

Read Explanation

International Business

Read Explanation

Influences On Business

Read Explanation
View all explanations

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.

Sign-up for free