Question

Cardinals Co issued $6,000,000 of 8%, 15-year bonds on 5/1/18 plus accrued interest at a time when the market rate of interest was 5%. The bonds have an authorized date of 3/1/18 and pay interest each 3/1 and 9/1. The effective-interest method is used to amortize any discount or premium.

** REQUIRED: 1) Determine the following items: a) issue price of the bonds. 7869408 b) amount of discount or premium (indicate which) for which the bonds were issued. 1869408 c) carry value of the bonds after the 2nd interest payment on 3/1/19. 7796823 ?Here are the correct answers. Can you please explain how they were computed.

Answer 1

1)

a)Issue price of bond - Issue price is the price at which investors buy the bonds when they are first issued. The net proceeds that the issuer receives are calculated as the issue price, less issuance fees , discounts or adding premium amount paid to buy bond. In given case Bonds are given at premium of $ 18,69,408 .

Hence issue price here = FACE VALUE + PREMIUM PAID = $ 60,00,000 + $ 18,69,408

b) Premium is extra amount paid to buy bond due to high market value / returns.

When a bond is issued at a premium, that means that the bond is sold for an amount greater than the bond's face value. This generally means that the bond's contract rate is greater than the market rate.

Here premium for which bonds were issued = $ 18,69,408

c) When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond. In other words, the credit balance in the account Premium on Bonds Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the accounting periods that the bond is outstanding.

The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond's book value. This means that when a bond's book value decreases, the amount of interest expense will decrease. In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium.

Carrying Value calculations are as follows :

Date	Interest Payment - 4%	Interest Expense - 2.5%	Amortisation of bond	Credit balance in bond premium	Credit balance in bond payable account	book value of bond
(a)	(b)= Face Value * Interest Rate	(c') = Book value(g) * Market Rate	(d) = C - B	(e')	(f)	(g)
5/1/18				1869408	6000000	7869408
9/1/18	160000*	131401***	-28599	1840809	6000000	7840809
3/1/19	240000**	196020****	-43980	1796829	6000000	7796823

* 60,00,000 * 4%/6*4 = 160000

**60,00,000 * 4% = 240000

*** 7869408*2.5%/6*4 = 131401

****7840809 * 2.5% = 196020

Note : 1) Interest is considered 4 % for 6 months period as annually its 8%

2)Market rate is considered 2.5% for 6 months period as annually its 5%