Amortization of a Bond Discount and Premium On September 1, 2011, Rodriguez Plum
ID: 2415580 • Letter: A
Question
Amortization of a Bond Discount and Premium
On September 1, 2011, Rodriguez Plumbing Company issued $5 million in 10-year, 12 percent bonds payable. Interest is payable semiannually on March 1 and September 1. Bond discounts and premiums are amortized at each interest payment date and at year-end. The company’s fiscal year ends at December 31.
Instructions
a.Make the necessary adjusting entries at December 31, 2015, and the journal entry to record the payment of bond interest on March 1, 2016, under each of the following assumptions:
1. The bonds were issued at 98. (Round to the nearest dollar.)
2. The bonds were issued at 104. (Round to the nearest dollar.)
b.Compute the net bond liability at December 31, 2016, under assumptions 1 and 2 above. (Round to the nearest dollar.)
c.Under which of the above assumptions, 1 or 2, would the investor’s effective rate of interest be higher? Explain
Explanation / Answer
(a)
Case I. Issued at 98
Bond issued @ 2% discount i.e.
Discount = $5,000,000 x 2% = $ 100,000
Discount shall be amortised equally over 10 years i.e. life of bond
Then amount of discount to be amortised on December 31, 2015 = ((100,000 )/(10 x 12)) x 4 = $ 3,333
The amount of interest on bond to be transferred to Statement of Comprehensive Income or Profit and Loss Account or Statement of Profit and Loss = $ 5,000,000 x 12% = $ 600,000
Adjusting entry on December 31, 2015 shall be
Statement of Comprehensive Income - Dr $ 603,333
To Discount on Issue of Bonds Account $ 3,333
To Interest on Bonds Account $ 600,000
(Being discount on Issue of Bonds and interest on bonds amortised)
Journal Entry to Record Payment of Bond Interest on March 1, 2016 shall be
Interest on Bond Account -Dr $ 300,000
To Interest on Bond Payable/ Bank Account $ 300,000
(Being interest on bond paid for period September 1, 2015 to Feb 29, 2016 i.e. 6 months)
Case II. Issued at 104
Bond issued @ 4% premium i.e.
Premium = $5,000,000 x 4% = $ 200,000
Premium shall be amortised equally over 10 years i.e. life of bond
Then amount of premium to be amortised on December 31, 2015 = ((200,000 )/(10 x 12)) x 4 = $ 6,667
The amount of interest on bond to be transferred to Statement of Comprehensive Income or Profit and Loss Account or Statement of Profit and Loss = $ 5,000,000 x 12% = $ 600,000
Adjusting entry on December 31, 2015 shall be
Premium on Issue of Bonds Account -Dr $ 6,667
Statement of Comprehensive Income -Dr $ 593,333
To Interest on Bonds Account $ 600,000
(Being premium on Issue of Bonds and Interest on bonds amortised)
Journal Entry to Record Payment of Bond Interest on March 1, 2016 shall be
Interest on Bond Account -Dr $ 300,000
To Interest on Bond Payable/ Bank Account $ 300,000
(Being interest on bond paid for period September 1, 2015 to Feb 29, 2016 i.e. 6 months)
(b)
Case I. Issued at 98
Net Bond Liability at December 31, 2016
12 % Bonds $ 5,000,000
Interest on Bonds Accrued but not due $ 200,000
Discount on Issue of Bond $ 46,667
Net Bond Liability = $ 5,000,000 + $ 200,000 +$ 46,667 = $ 5,246,667
Case II. Issued at 104
Net Bond Liability at December 31, 2016
12 % Bonds $ 5,000,000
Interest on Bonds Accrued but not due $ 200,000
Premium on Issue of Bonds $ 93,333
Net Bond Liability = $ 5,000,000 + $ 200,000 - $ 93,333 = $ 5,106,667
(c)
Case I. Issued at 98
Effective Rate of Interest = (Total Interest received by investors)/(Total amount paid by investors)
= ($ 5,000,000 x 12% x 6/12 x 2 x 10)/($ 5,000,000 x 98%)
= 122.45%
Case II. Issued at 104
Effective Rate of Interest = (Total Interest received by investors)/(Total amount paid by investors)
= ($ 5,000,000 x 12% x 6/12 x 2 x 10)/($ 5,000,000 x 104%)
= 115.38%
Thus, the investor's effective rate of interest is higher in case Bond is issued at a discount as the investor is paying less to receive fixed interest income if he is paying $ 98 for each bond as compared to when he is paying $ 104 for each bond.
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