301421 Computation of Issue Price of Bonds Payable 2H1

Question 1

If a premium on a bonds payable transaction is not amortized, what are the effects on interest expense and total stockholders’ equity?

Interest expense: understated; Total stockholders’ equity: understated

Interest expense: overstated; Total stockholders’ equity: overstated

Interest expense: understated; Total stockholders’ equity: overstated

Interest expense: overstated; Total stockholders’ equity: understated

Question #301421

Answer 1

Interest expense: overstated; Total stockholders’ equity: understated

When a bond is issued for a premium, then the issuer receives more than the face amount of the debt upon issuance. Thus, the issuer will pay back (the face amount) less than the amount received. The additional receipts lower the interest expense over the course of the repayment, since the overall net repaid amount is less. As the bonds are repaid, the premium is amortized and lowers the interest expense taken over the term of the bond. If the amortization is not taken, then the interest expense is overstated, and the net income understated. (Thus, retained earnings and stockholder’s equity are also too low.)

Question 2

Amortization

Answer 2

Amortization is an accounting process for reducing an asset or liability by periodic payments or writedowns that are distributed across the time the organization gains a value from or has obligation for the item. Specifically, it is the process of reducing a liability recorded as a result of a cash receipt (e.g., unearned revenue) by recognizing revenues or reducing an asset recorded as a result of a cash payment (e.g., prepaid expenses) by recognizing expenses or costs of production.

SFAC 6.142

Amortization is an allocation process to orderly reduce bond premium, bond discount, and bond issue costs by allocating the cost of an intangible asset to expense over time.

Question 3

Premium

Answer 3

Premium is the excess of proceeds (cash paid) on a bond over the face value of the bond. A bonus (i.e., the borrower receives proceeds more than the face value) is considered a premium, which is in contrast to a discount. A premium results when the stated interest rate is greater than the effective (market) rate. A premium is amortized over the life of the bond with the amount of amortization reported as interest, and it is also the difference between the present value of the bond and its face value (where the face value is lower). A premium is recorded on the balance sheet as an adjunct account inseparable from the bond that gives rise to it. It must be disclosed on the balance sheet as a direct addition to the face amount of the bond.

Example: A bond at face value is a $1,000, 20-year bond bearing interest at 10% annually where the stated interest rate is 10% and cash interest paid is $100 per year. If the prevailing market rate is 8%, the bond will sell for more than $1,000 (proceeds received will equal $1,197) because the lender could only earn 8% on any other investment (so this bond’s market value is more than its face value). The bond sells at a premium.

i = .08, n = 20, (PVA × 100) = (9.82 × 100) + (PV × 1,000) = (.215 × 1,000)
Selling price = 982 + 215 = 1,197
Premium = 1,197 - 1,000 = 197

Question 4

2282.01

Answer 4

Computation of Issue Price

When a bond is issued, the bond contract (indenture) specifies the amount and timing of payments the issuer is obligated to pay. The issuer will pay the following:

The face or principal amount at the maturity date of the bonds
Interest at specified intervals, usually semi-annually, during the life of the bond based on a stated percentage of the face amount
The interest rate stated in the bond contract is known variously as the stated, coupon, contract, or nominal rate.

Question 5

2282.02

Answer 5

The effective interest the issuer will pay is determined in the marketplace, not in the bond contract. At any given time, a market rate of interest exists. This is the rate that the investor (purchaser of a bond) can command in the marketplace for the particular type of bond and risk level. Accordingly, the investor is not willing to accept a return on the investment that is less than the market rate. Alternatively, the market rate of interest can be viewed as the rate that the issuer of the bonds can command in the marketplace. The issuer is not willing to pay any more for the use of the investor’s money than the market requires.

a. If the coupon rate is greater than the market (or effective) rate, the bonds will sell at a premium (i.e., at an amount greater than the face amount of the bonds).
b. If the coupon rate is less than the market rate, the bonds will sell at a discount. The issue price is determined by discounting the payments (principal and interest) to the present using the effective or market rate of interest.

Question 6

2282.03

Answer 6

Debt issuance costs related to a debt liability are presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts.

Question 7

2282.04

Answer 7

Question 8

2282.05

Answer 8

Amortization of Premium or Discount

Any discount or premium should be amortized by using the interest method, which results in a constant rate of interest. Other methods, such as the straight-line method (a constant amount per period) may be used if the results are not materially different.

Question 9

2282.06

Answer 9