Question

Mills Corporation acquired as a long-term investment $200 million of 7% bonds, dated July 1, on July 1, 2018. Company management has the positive intent and ability to hold the bonds until maturity. The market interest rate (yield) was 5% for bonds of similar risk and maturity. Mills paid $240 million for the bonds. The company will receive interest semiannually on June 30 and December 31. As a result of changing market conditions, the fair value of the bonds at December 31, 2018, was $210 million. Required: 1. & 2. Prepare the journal entry to record Mills’ investment in the bonds on July 1, 2018 and interest on December 31, 2018, at the effective (market) rate. 3. At what amount will Mills report its investment in the December 31, 2018, balance sheet? 4. Suppose Moody’s bond rating agency upgraded the risk rating of the bonds, and Mills decided to sell the investment on January 2, 2019, for $250 million. Prepare the journal entry to record the sale.

Answer 1

Answers

1.Prepare the journal entry to record Mills’ investment in the bonds on July 1, 2018

Investments in Bonds A/c…………………$200,000,000

Premium on Bond investment A/c………$40,000,000

               To Cash A/c………………………………………………..$240,000,000

Explanation: Here, Mills Corporation acquired as a long-term investment $200 million on July 1, 2018. So, the fair value of Bonds is $200 million. But, Mills paid $240 million for the bonds, which means Mills paid $40 million in extra to the fair value of $200 million. This $40 million is the premium on bond investment.

……………………………………………………………………………………………………………………

2. Prepare the journal entry to record interest on December 31, 2018, at the effective (market) rate.

Cash A/c (200,000,000*7%*6/12)………. $7,000,000

                 To Interest Revenue A/c (240,000,000*5%*6/12)………….6000,000

                 To Premium on Bonds A/c…………………………………$1000,000

Explanation: Here, Mills Corporation receiving interest semi-annually, therefore we have calculated Interest for 6 months. Interest revenues at the effective (market) rate at 5% is $6,000,000, which is less than the actual Interest received at 7%. Because Mills paid premium on bonds. So $1,000,000 is as an amortization or write off on Premium on Bonds.

……………………………………………………………………………………………………………………

3. At what amount will Mills report its investment in the December 31, 2018, balance sheet?

The Book value of Investments in Bonds will be calculated as follows;

Investment in Bonds	$200,000,000
Add: Unamortised Premium on Bonds
Premium on Bond……………….………...$40,000,000
Amortised Premium on Bonds…………$(1,000,000)	$39,000,000
Book Value of Held-to-Maturity Investments	$239,000,000

Explanation: Here, the Investment is classified as “Held-to-Maturity”, since it is mentioned that the Mills has ability to hold the bonds until maturity. While calculating book value, we are adding unamortised portion of premium on bonds.

........................................................................................................................................................

4. Suppose Moody’s bond rating agency upgraded the risk rating of the bonds, and Mills decided to sell the investment on January 2, 2019, for $250 million. Prepare the journal entry to record the sale.

Cash A/c…………………………..$ 250,000,000

                       To Premium on Bonds A/c………………..$ 39,000,000

                       To Gain on Sale A/c………………………. $11,000,000

                       To Investment in Bonds A/c……………….$ 200,000,000

Explanation: Gain on sale is calculated by deducting Book value of $239,000,000 from fair value $250,000,000. Here we are eliminating Investment in Bonds and Premium on Bonds since the investment is sold.