Question

On March 1, 2011, Amel Company soldits 5-year, $1,000 face value, 9% bonds dated March 1, 2011, at an effective annual interest rate (yield) of11%. Interest is payable semiannually, and the first interest payment date is September 1, 2011. Amel usesthe effective-interest method of amortization. Bond issue costs were incurred in preparing and selling thebond issue. The bonds can be called by Amel at 101 at any time on or after March 1, 2012.

(a) (1) How would the selling price of the bond be determined? *

(2) Specify how all items related to the bonds would be presented in a balance sheet prepared immediately after the bond issue was sold. *

(b) What items related to the bond issue would be included in Amel’s 2011 income statement, andhow would each be determined? *

(c) Would the amount of bond discount amortization using the effective-interest method of amortizationbe lower in the second or third year of the life of the bond issue? Why? *

(d) Assuming that the bonds were called in and retired on March 1, 2012, how should Amel report the retirement of the bonds on the 2012 income statement? *

Answer 1

(a)        1. The selling price of the bonds would be the present value of all of the expected net future cash outflows discounted at the effective annual interest rate (yield) of 11 percent. The present value is the sum of the present value of its maturity amount (face value) plus the present value of the series of future semiannual interest payments.

            2. Immediately after the bond issue is sold, the current asset, cash, would be increased by the proceeds from the sale of the bond issue. A noncurrent liability, bonds payable, would be presented in the balance sheet at the face value of the bonds less the discount. The bond issue costs would be classified as a “noncurrent asset, deferred charge” under generally
accepted accounting principles; however, there is theoretical justification for classifying the bond issue costs as either an expense or a reduction of the related debt liability.

(b)        The following items related to the bond issue would be included in Sealy's 2011 income statement:
1. Interest expense would be included for ten months (March 1, 2011, to December 31, 2011) at an effective-interest rate (yield) of 11 percent. This is composed of the nominal interest of 9 percent adjusted for the amortization of the related bond discount. Bond discount should be amortized using the effective-interest method over the period the bonds will be outstanding, that is, the period from the date of sale (March 1, 2011) to the maturity date (March 1, 2016).

            2. Interest expense (or bond issue expense) would be included for ten months of amortization of bond issue costs (March 1, 2011 to December 31, 2011). Bond issue costs should be amor­tized over the period the bonds will be outstanding, that is, the period from the date of sale (March 1, 2011) to the maturity date (March 1, 2016). However, there is theoretical justification for classifying the total bond issue costs as an expense.

(c)        The amount of bond discount amortization would be lower in the second year of the life of the bond issue. The effective-interest method of amortization uses a uniform interest rate based upon a changing carrying value which results in increasing amortization each year when there is a bond discount.

(d)       The retirement of the bonds would result in a loss from extinguishment of debt that should be included in the determination of net income and classified as an ordinary loss.