Question

Problem Two cont...

On January 1, 2017, Ashlock Chemical AG issued €4,000,000, 10%, 10-year bonds at €4,543,627. This price resulted in an 8% effective-interest rate on the bonds. Ashlock uses the effective-interest method to amortize bond premium or discount. The bonds pay interest semi-annually on January 1 and July 1. Rounding to two decimal places, answer the following:

a) Use Present Value of 1 Table and Present Value of an Annuity of 1 Table, and your knowledge of time value of money, to prove why the bonds were issued at $4,543,626. Then prepare the JE for the issuance on January 1, 2017. If your calculations differ due to rounding, use the $4,543,626 figure for the issuance JE and the subsequent requirements. (Special side note: if interest were paid annually, the textbook figure of $4,543,626 would be incorrect. Assuming annual interest payments, the PV would be $4,536,792! (You may want to prove this on your own.)

b) Assuming the bonds are redeemed at maturity, what is the total amount of interest expense to be recognized over the life of the bonds? Show your work.

c) Assume the company has an annual accounting period ending the end of February.

1. Prepare the AJE required on February 28, 2017.

2. Prepare the journal entry to record the payment of interest on July 1, 2017

d) Ignore (c). Assume the annual accounting period ends on December 31 instead.

1.Prepare the journal entry to record the payment of interest on July 1, 2017.

2. Prepare the AJE required on December 31, 2017

3.Prepare the journal entry to record the payment of interest on January 1, 2018.

4. What is the carrying value of the bonds on January 1, 2018? Show your calculations

e) Assume that after interest is paid on January 1, 2018, the company buys back the bonds. On that date, the market interest rate was 12%.

1.Calculate what the company must pay to redeem the bonds. (Hint: This requires time value of money calculations.)

2.Prepare the journal entry to record the redemption.

3.Using a residual analysis, explain why a gain/loss must be recognized; also explain where on the SOCI the gain/loss would appear.

4.Assume a gain was realised. Assess the immediate impact on the debt/asset ratio. What will be the impact on the interest cover ratio for the financial year ending December 31, 2018 (compared with the previous financial year)?

Answer 1

1. a. Since the coupon payments are semiannual,

i = 8 % x 1/2 = 4 %

n = 10 years x 2 = 20

Coupons = $ 4,000,000 x 10% x 1/2 = 200,000.

Present value of bonds = Semiannual coupons x PVA _{4%, n=20} + Par Value x PV _{4%, n=20}

= 200,000 x 13.5903 + 4,000,000 x 0.4564 = 2,718,060 + 1,825,600 = 4,543,660

Date	Account Titles	Debit	Credit
		$	$
Jan 1, 2017	Cash	4,543,627
	Bonds Payable		4,000,000
	Premium on Bonds Payable		543,627

b. Total amount of interest expense to be recognized over the life of the bonds = Total coupon payments - Premium on Bonds Payable = ( 4,000,000 x 5% x 20) - 543,627 = 3,456,373.

c.

Transaction	Date	Account Titles	Debit	Credit
1.	Feb 28, 2017	Interest Expense ( 4,543,627 x 8% x 2/12)	60,581.69
		Premium on Bonds Payable	6,085.31
		Interest Payable ( 4,000,000 x 5 % x 2/6)		66,667
2.	July 1, 2017	Interest Expense ( 4,543,627 - 6,085.31) x 4 % x 4/6	121,001.11
		Interest Payable	66,667
		Premium on Bonds Payable	12,331.89
		Cash		200,000

d.

Transaction	Date	Account Titles	Debit	Credit
1.	July 1, 2017	Interest Expense ( 4,543,627 x 4%)	181,745.08
		Premium on Bonds Payable	18,254.92
		Cash		200,000
2.	Dec 31, 2017	Interest Expense	181,014.88
		Premium on Bonds Payable	18,985.12
		Interest Payable		200,000
3.	Jan 1, 2018	Interest Payable	200,000
		Cash		200,000

4. Carrying value of the bonds as on January 1, 2018 = 4,543,627 - 18,254.92 - 18,985.12 = 4,506,386.96

e. 1. The company must pay $ 3,566,720 to redeem the bonds.

Remaining life of the bonds = 9 years.

Therefore n = 9 x 2 = 18.

i = 12 % x 1/2 = 6% .

Present value of the bonds = $ 200,000 x 10.8276 + $ 4,000,000 x 0.3503 = $ 2,165,520 + $ 1,401,200 = $ 3,566,720.

2.

Date	Account Titles	Debit	Credit
		$	$
Jan 1, 2018	Bonds Payable	4,000,000
	Premium on Bonds Payable	506,386.96
	Cash		3,566,720
	Gain on Redemption of Bonds		939,666.96

3. As it is a realized gain, it will not appear in the SOCI. Rather it will be recognized in the Income Statement.

4. Debt / Asset ratio will decrease.Interest cover ratio will increase.

Debt/Asset ratio = Total Debt / Total Assets.

Redemption of the bonds will result in decrease in total debt. As the numerator decreases, it will lead to a reduction in the Debt/ Assets ratio.

Interest cover = Operating Income / Interest Expense.

As the bonds are redeemed, there would be no interest expense thereon henceforth. Therefore denominator decreases, resulting in an increase in the interest cover ratio.