In: Accounting
Djinn Co. made two bond investments on 1/1/17:Investment A: $5,000,000, 8% 10-year bonds that pay interest annually on 12/31 of each year. The market rate of bonds with a comparable risk was 9%. These bonds were classified as held-to-maturity (HTM). The market rate of these bonds at 12/31/17 was 8%.Investment B: $4,000,000, 6% 10-year bonds that pay interest annually on 12/31 of each year. The market rate of bonds with a comparable risk was 7%. These bonds were classified as available for sale (AFS). The market rate of these bonds at 12/31/17 was 7%.1. Provide the balance sheet value for each of these investments at 12/31/17.2. Provide income statement (net income and other comprehensive income) effects for each of these bonds. 3. Provide statement of cash flow effects for each of these bonds.
Bond 1
The present value of the bond is computed as :
(8%X 5,000,000 X (1-(1+9%)-10)/9%) + 5,000,000 X(1=9%)10 = 4,679,117
The discount on the bond purchase would be $5,000,000 - $4,679,117 = 320,883
Balance Sheet Impact:
At Inception
Cash(Asset) decreases by $4,679,117
Investment in Bonds(Asset) increases $5,000,000
Discount on Bonds(Liability) increases by $320,883
Annually
Cash(Asset) increases by 8% X 5,000,000 = $400,000
Discount on Bonds(Liability) decrease by 320,883/10 = $32,088.3
Income Statement Impact:
Annually
Interest Income increases by 8% X 5,000,000 + 32,088.3 = $432,088.3
Cash Flow Impact:
Inception
Cash outflow of $4,679,117
Annually
Cash inflow of = $400,000
Note: Held to Maturity bonds are not adjusted for changes in fair value. Hence the market interest rate for these bonds do not matter.
Bond 2
These bonds would be accounted similar to the above. Except that the carrying value of the bond would be adjusted for any changes in the Fair Value.
The present value of these bonds are $3,719,056
Balance Sheet Impact:
At Inception
Cash(Asset) decreases by $3,719,056
Investment in Bonds(Asset) increases $4,000,000
Fair Value Adjustments(Liability) increases by $280,943
Annually
Cash(Asset) increases by 8% X 5,000,000 = $400,000
Fair Value Adjustment(Liability) decrease by 280,943/10 = $28,094.3
Income Statement Impact:
Annually
Interest Income increases by 6% X 4,000,000 = $240,000
Unrealized Gain/Loss(Other Comprehensive Income) = $28,094.3
Cash Flow Impact:
Inception
Cash outflow of $3,719,056
Annually
Cash inflow of = $240,000