Module 3

Question 1

On January 1, 2017, Kimbrough Inc. issued $5,000,000, 9% bonds for $4,695,000. The market rate of interest for these bonds is 10%. Interest is payable annually on December 31. Kimbrough uses the effective-interest method of amortizing bond discount.

What value would Kimbrough report for the unamortized bond discount on December 31, 2017?

Answer 1

$285,500

When the bond is purchased for less than the face value of the bond, the bond is “issued at a discount” of $305,000 ($5,000,000 - $4,695,000). The cash payment on the bond is $450,000 ($5,000,000 x 9% x 12/12). On 01/01/2017, the carrying amount of the bond is $4,695,000. Total interest expense on December 31, 2017 is $469,500 ($4,695,000 x 10% x 12/12). On June 30, the carrying value of the bond is increased (the discount is decreased) by $19,500 ($469,500 - $450,000) to $4,714,500 ($4,695,000 + $19,500). The original discount of $305,000 is reduced by $19,500 to $285,500.

Question 2

On June 30, 2017, Prouty Co. had outstanding 9%, $5,000,000 face amount, 10-year bonds that pay interest semi-annually on June 30 and December 31. The unamortized balance in the bond discount account on June 30, 2017 was $200,000. On June 30, 2017, Prouty acquired all of these bonds at 101 and retired them.

What amount of gain or loss would Prouty record on this early extinguishment of debt?

Answer 2

$250,000 loss
Correct. When a bond is redeemed, any excess of net carrying amount over the reacquisition prices is a “loss from extinguishment” The reacquistion price is $5,050,000 ($5,000,000 x 1.01). The book value of the bond is the face value less any unamortized discount. In this case, the book value is $4,800,000 ($5,000,000 - $200,000). Therefore, the loss on extinguishment is $250,000 ($5,050,000 - $4,800,000).

Question 3

A company issues $25,000,000, 7.8%, 20-year bonds to yield 8% on January 1, 2020. Interest is paid on June 30 and December 31. The proceeds from the bonds are $24,505,180.

Using effective-interest amortization, how much interest expense will be recognized in 2020?

Answer 3

$1,960,622

When a bond is purchased for less than the face value of the bond, the bond is “issued at a discount” of $494,820 ($25,000,000 - $24,505,180). The cash payment on the bond is $975,000 ($25,000,000 x 7.8% x 6/12). On 01/01/2020, the carrying amount of the bond is $24,505,180. Total interest expense on June 30, 2020 is $980,207 ($24,505,180 x 8% x 6/12). On June 30, the carrying value of the bond is increased (the discount is reduced) by $5,207 ($980,207 - $975,000) to $24,510,387 ($24,505,180 + $5,207). Total interest expense on December 31, 2020 is $980,415 ($24,510,387 x 8% x 6/12). Therefore, total interest expense for 2017 is $1,960,622 ($980,207 + $980,415).

Question 4

On January 1, 2021, Jacobs Company sold property to Dains Company which originally cost Jacobs $2,660,000. There was no established exchange price for this property. Danis gave Jacobs a $4,200,000 zero-interest-bearing note payable in three equal annual installments of $1,400,000 with the first payment due December 31, 2021. The note has no ready market. The prevailing rate of interest for a note of this type is 10%. The present value of a $4,200,000 note payable in three equal annual installments of $1,400,000 at a 10% rate of interest is $3,481,800.

What is the amount of interest income that should be recognized by Jacobs in 2021, using the effective-interest method?

Answer 4

$348,180

When a note is issued at zero percent, the discount is amortized using the implicit interest rate calculated by evaluating the present value of future cash flows. In this case, the implicit interest rate is given as 10%. Similar to bonds, the difference of a note’s face value and the present value is booked as a discount and amortized to interest expense over the life of the note. The book value of the bond is the face value less any unamortized discount. In this case, the book value is given as $3,481,800. Interest income for Jacobs for 2021 is $348,180 ($3,481,800 x .10).