Question

Financial Accounting

1. Describe the Straight-line depreciation method. Explain a real-life business example of an actual fixed asset being depreciated using the Straight-line depreciation method. (Review pages 454 to 457 & pages 476 to 478)

2. Describe a bond issued at par.  Explain why an investor would purchase a bond issued at par instead of a bond issued at a discount or a bond issued at a premium. (Review pages 515 to 520).

Answer 1

Question1: Straight-line depreciation method

Straight line depreciation method charges cost evenly throughout the useful life of a fixed asset. This depreciation method is appropriate where economic benefits from an asset are expected to be realized evenly over its useful life.

Straight line method is also convenient to use where no reliable estimate can be made regarding the pattern of economic benefits expected to be derived over an asset's useful life.

Formula

Straight line depreciation can be calculated using any of the following formulas:

Depreciation per annum

=

( Cost − Residual Value )/ useful life

Depreciation per annum =		( Cost − Residual Value ) x Rate of depreciation

Example

A fixed asset having a useful life of 3 years is purchased on 1 January 2018.

Cost of the asset is $2,000 whereas its residual value is expected to be $500.

Calculate depreciation expense for the years ending 30 June 2018 and 30 June 2019.

Depreciation expense per annum shall be:	=		($2000 − $500)/ 3 years =  $500 p.a.

Depreciation expense for the year ended 30 June 2018:

$500 x 6/12 = $250

As $500 calculated above represents the depreciation cost for 12 months, it has been reduced to 6 months equivalent to reflect the number of months the asset was actually available for use.

Depreciation expense for the year ended 30 June 2019:

$500 x 12/12 = $500

As the asset was available for the whole period, the annual depreciation expense is not apportioned.

Question 2: Bond Issued at par

One of the most important characteristics of a bond is its par value. The par value is the amount of money that bond issuers promise to repay bondholders at the maturity date of the bond. A bond is essentially a written promise that the amount loaned to the issuer will be repaid.

The coupon rate of a bond determines whether a bond will trade at par, below par, or above its par value. The coupon rate is the interest payments that are made to bondholders, annually or semi-annually, as compensation for loaning the issuer a given amount of money. For example, a bond with par value of $1,000 and a coupon rate of 4% will have annual coupon payments of 4% x $1,000 = $40. A bond with par value of $100 and a coupon rate of 4% will have annual coupon payments of 4% x $100 = $4. If a 4% coupon bond is issued when interest rates are 4%, the bond will trade at its par value since both interest and coupon rates are the same.

However, if interest rates rise to 5%, the value of the bond will drop, causing it to trade below its par value. This is because the bond is paying a lower interest rate to its bondholders compared to the higher interest rate of 5% that similar-rated bonds will be paying out. The price of a lower-coupon bond therefore must decline to offer the same 5% yield to investors. On the other hand, if interest rates in the economy fall to 3%, the value of the bond will rise and trade above par since the 4% coupon rate is more attractive than 3%.

Regardless of whether a bond is issued at a discount or premium, the issuer will repay the par value of the bond to the investor at the maturity date. Say, an investor purchases a bond for $950 and another purchases the same bond for $1,020. On the bond's maturity date, both of the investors will be repaid $1,000 par value of the bond.