Question

During Year 1 and Year 2, Agatha Corp. completed the following transactions relating to its bond issue. The corporation’s fiscal year is the calendar year.

Year 1

Jan. 1 Issued $310,000 of 10-year, 6 percent bonds for $298,000. The annual cash payment for interest is due on December 31.

Dec. 31 Recognized interest expense, including the straight-line amortization of the discount, and made the cash payment for interest.

Dec. 31 Closed the interest expense account.

Year 2

Dec. 31 Recognized interest expense, including the straight-line amortization of the discount, and made the cash payment for interest.

Dec. 31 Closed the interest expense account.

Required

a-1. When the bonds were issued, was the market rate of interest more or less than the stated rate of interest?

a-2. If Agatha had sold the bonds at their face amount, what amount of cash would Agatha have received?

b. Prepare the liabilities section of the balance sheet at December 31, Year 1 and Year 2.

c. Determine the amount of interest expense that will be reported on the income statements for Year 1 and Year 2.

d. Determine the amount of interest that will be paid in cash to the bondholders in Year 1 and Year 2.

Answer 1

a-1
The bonds are issued at discount which means the market interest rate was higher than the coupon rate or the stated rate of interest
a-2
If bonds were sold at face value, company would have received $310,000 in cash this would have happended if coupon rate is equal to market interest rate
b
Discount on bond (310000-298000)		12000
Straight line depreciation (12000/10)		1200
Agatha Corp
Partial Balance Sheet
As on year ended for Year 1
Long term liabilities
Bonds payable	$310,000
Discount on bond	-$10,800	$299,200
(12000-1200)
Agatha Corp
Partial Balance Sheet
As on year ended for Year 2
Long term liabilities
Bonds payable	$310,000
Discount on bond	-$9,600	$300,400
(12000-(1200*2))
c
Interest expense = Cash interest + amortization of discount
Interest expense = (310000*6%) + 1200
Interest expense	$19,800
Since the discount is amortized using the straight line method the interest expense for year 1 and year 2 would be same that is $19,800
d.
Cash interest payment = Face value of bond*Coupon rate
Cash interest payment = 310000*6%
Cash interest payment	$18,600
The cash interest payment will be same for both year 1 and year 2 that is $18,600