On January 1 2018 Entity A issued 8 bonds dated January 1 20

On January 1, 2018, Entity A issued 8% bonds dated January 1, 2018, with a face amount of $10 million. The bonds mature in 2022 (5 years). For bonds of similar risk and maturity, the market yield is 10%. Interest is paid semiannually on June 30 and December 31. A. Prepare a partial balance sheet showing the bonds at December 31, assuming that Entity A had used the effective interest method from the inception. B. Why might a company utilize the straight-line method to amortize premium or discount? When is it permissible to do so?

Solution

Ans. A

Since bonds coupon rate of 8% is lower than market rate of 10% and bond is issued at discount. Market value of bonds will be arrived as follows:

Coupon payments = 10,000,000 x 8% x ½ = 400,000 for six month

Present value of coupon = $400,000 x 7.7217349* = $3,088,694

Present value of Face value = $10M x 0.6139133** = $6,139,133

Total of present values = $9,227,827

*Present value of ordinary annuity of $1 i = 5%, n = 10

** Present value of $1, I = 5%, n = 10

Discount on bonds = $10M - $9,227,827 = $772,173

Date

Interest Paid

Interest Expense

Discount amortized

Unamortized Discount

Carrying Value

January 1, 2018

                              772,173

           9,227,827

June 30, 2018

$              400,000

                   461,391

$                             61,391

$                           710,782

$        9,289,218

December 31, 2018

$              400,000

                   464,461

$                             64,461

$                           646,321

$        9,353,679

Balance Sheet (Partial)

Long term Debt:

Bonds Payable

$        10,000,000

Less: Unamortized Discount

$              646,321

Net Bonds Payable

$          9,353,679

Ans. B

Straight line amortization method amortizes equal $ amount to each period and easy to use and also, there is no significant difference from effective amortization so that can be the reason of using it.