Question

On July 1, 20X7, Rocky issued $2 million in bonds, payable in 10 years with semi-annual payments of 8% interest (APR). The market rate of interest at the time was 10%. The interest payments were due on December 31 and June 30 in each of the 10 years.  Also on December 31, 20X7, Rocky made the first payment on the $2 million bonds.

Need help with journal entries for issue and payments

Answer 1

Solution

Workings

Calculation of market price of bond

Interest is 4%(semi annual payment)*2,000,000=80,000

n=20 (10 years semi annual payment), i=5% (10% semi annual payment)

PV (Present value) of $1 at n=20 and i=5% is 0.3769

PV of bond is 2,000,000*0.3769 = $753,800

Cumulative PV of $1 at n=20 and i=5% is 12.462

PV of interest is 80,000*12.462 = $996,960

Market value of bond is PV of bond + PV of interest

Hence, Market value of bond is $753,800+$996,960 = $1,750,760

Calculation of interest expense

Stated rate or the annual nominal interest rate on the bond = 8%.

Since interest is payable semi-annually, periodic interest rate of the bond = stated rate/2 = 8%/2 = 4%

Amount of interest payable every semi-annual period = 2,000,000*0.04 = 80,000

Market value (or book value) of the bond at the beginning of the first period = $1,750,760

Nominal (annual) market interest rate = 10%.

Again, effective market interest rate for the semi-annual period = 10%/2 = 5%

Amount of interest on the market value of the bond for the first semi-annual period = $1,750,760*0.05 = $87,538

Calculation of discount and extra interest

Extra interest deductible on the Income Statement = $87,538 − $80,000 = $7,538

Book value of the bond at the end of the first period = $1,750,760+$7,538 = $1,758,298

Amount of discount at the beginning of the first period = $2,000,000 - $1,750,760 = $249,240

Amount of discount at the end of the first period = $249,240 - $ 7538 = $241,702

Journal entries

Date	Account name	Debit	Credit
01/07/20X7	Cash	1,750,760
	Discount on Bonds Payable	249,240
	Bonds Payable		2,000,000
31/12/20X7	Interest Expense	87,538
	Discount on Bonds Payable		7,538
	Cash		80,000

You are required to pay only $80,000 to the bondholder every semi-annual period, but you are allowed to deduct the amount of $87,538 as an interest expense in determining the Net Income of the company. The extra amount of interest expense you are allowed to deduct is the amount that is set aside so that it can be used to increase the book value of the bond and reduce the amount of discount.

These calculations can be repeated for periods 2 through 20 with the understanding that the book value of the bond at the end of one period will be the book value at the beginning of the next period.