Bonds
Hard Practice Test
Intermediate Accounting 2
Hard Practice Test
Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.
1. Which of the following is a reason to issue bonds rather than common stock?
a. interest payments reduce income taxes paid
b. bondholders have more voting rights than common stockholders
c. net income is higher when bonds are issued
d. cash received from bonds will always be higher than received from stock
Answer
A. Interest expense lowers net income (c) which lowers income tax paid. Dividends paid on common stock are not expenses, are not tax deductible and do not lower taxes paid. Bondholders do not have voting rights. (d.) depends on current leverage of the company.
2. When a bond is sold at a premium, amortization of the premium is
a. an increase to interest expense
b. a decrease to interest expense
c. an increase to the premium
d. an increase to the amount owed
Answer
B. A premium occurs when more cash is received than will be repaid at maturity. As the premium is lowered each period, the net amount owed is lower, decreasing interest expense. Interest expense is lower than cash paid for interest.
3. Which is true when a bond is issued at a discount?
a. the amount the discount is reduced is lower each period
b. the amount of interest expense is higher each period
c. the amount of interest expense is lower each period
d. the net amount owed will eventually be less than the discount
Answer
B. Less cash is received than will be repaid on the maturity date. The net amount owed increases with each interest payment. As the amount owed increases, interest expense increases. The difference in cash paid and the interest expense is greater as interest expense is higher and cash paid remains the same (a.)
4. The company issued a $10,000, 5-year, 10% bond that pays semiannually. The market rate of interest was 12% at the time of issuance. The interest expense recorded with the first payment will be
a. higher than $500
b. lower than $500
c. equal to $1,000
d. lower than $120
Answer
A. When the market rate is higher than the stated rate, interest expense will also be higher than cash paid each period. The cash paid will be $10,000 x .10 / 2 = $500 Interest expense will be higher than the periodic cash payment.
5. When a bond is issued at a lower rate of market interest than the stated rate
a. the cash received is lower than maturity value
b. the cash received is higher than maturity value
c. interest expense will be higher than cash paid
d. the net amount owed at the end of the period will increase with each payment made for interest
Answer
B. To incur a lower rate of interest, more cash must be received. Interest expense will be lower than the stated rate/cash paid (c.) When more cash is received, the net amount owed (carrying value) decreases each period to get down to maturity value (d).
6. The issue price of a 0 stated bond will be
a. higher than maturity value
b. lower than maturity value
c. issued at a premium
d. issued at par
Answer
B. When no stated is paid, the interest that would have been paid periodically is added to the price of the bond to get to the maturity value on the maturity date. Since interest not paid is added, the issue price is much lower than the maturity value when issued.
7. When the typical rate earned by an investor for a company of equivalent risk and economic situation is lower than the stated/stated rate, the bond will be issued at
a. an amount less than maturity value
b. an amount greater than maturity value
c. par value
d. a discount
Answer
B. The typical rate earned is the market effective rate. When the market rate is lower than the stated rate, more cash is received than maturity value. This is a premium. Par occurs only when the two rates are equal.
8. As market interest rates increase, the selling price of a bond
a. does not change, it stays at the issue price
b. increases
c. decreases
d. increases at a rate proportionate to the percentage increase in the market rate
Answer
C. When rates are higher, less cash is required to earn the return. The selling price of the bond is the cash exchanged. Higher rates decrease the price of a bond. The present value of future cash flows prevents the increase in price from being equal to the % increase in rates (d).
9. A company registered to issue a 10%, 20-year bond when the market rate was 10%. Prior to issuing the bond, market rates increased to 11%. The company must
a. re-register the bond contract
b. expect to receive more cash than was originally planned
c. change the stated interest rate to match the current market rate
d. expect to receive less cash than was originally planned
Answer
D. The bond contract will not change when economic factors change. A higher market rate means that less cash will be received from the investor earning a higher return.
10. When the market rate changes after issuing the bond, the company
a. incurs the same rate of interest expense
b. will have interest expense that changes with market rate changes
c. pays a different amount for interest as market rates change
d. both b. & c.
Answer
A. Future market rate changes do not affect the bond contract or the amount of interest expense incurred by the company. Interest expense is locked in for the company when the bond is issued based on the market rate at the time of issuance. Trades between investors does not affect the company.
A. Compute the price of the bond on the actual issue date
B. Prepare the amortization schedule for the bond for the first 4 payments
C. Record the issuance of the bond and the first interest payment made for the issuer.
D. Record the purchase of the bond and the second interest payment received
for the investor who owns 10% of the total bond issued.
E. Record the entry for redemption of the bonds on July 31st of the 2nd bond year for the issuer.
Answer
Market rate changes after issuing the bond have no impact on the company.
A. 5% for 10 periods
| 500,000 x 8%/2 = 20,000 x 7.72173 = 154,435 500,000 x .61391 = 306,955 461,390 Effective Interest + 3,845 Cash Interest – 3,333 Present value on actual issue date is 461,902 |
B. Amortization Schedule –
Do the bond issue date and bond payment dates first and then insert rows for other dates
| (10% / 2) Effective Interest % |
(MV x 8% /2) Stated or Stated % |
|
|
End of Period Carrying Value |
|
| 5/1/y1 original issue date | 38,610 | 461,390 | |||
| 6/1/y1 (1/6) | 3,845 | 3,333 | 512 | 38,098 | 461,902 |
| 11/1/y1 | 23,070 | 20,000 | 3,070 | 35,540 | 464,460 |
| 5/1/y2 | 23,223 | 20,000 | 3,223 | 32,317 | 467,683 |
| 7/31/y2 | (3/6)11,692 | 10,000 | 1,692 | 30,625 | 469,375 |
| 11/1/y2 | 23,384 | 20,000 | 3,384 | 28,933 | 471,067 |
C. Issue and 1st Payment for the issuer
6/1/y1
Cash 465,235
Discount 38,098
Bond Payable 500,000
Interest Payable 3,333
11/1/y1
Interest Payable 3,333
Interest Expense 19,225
Discount 2,558
Cash 20,000
D. Purchase of the bond and 2nd payment, investor owns 10%
6/1/y1
Investment 46,190
Interest Receivable 333
Cash 46,523
5/1/y2
Cash 2,000
Investment 322
Interest Revenue 2,322
Multiply the amounts on the amortization schedule by 10%
E. Early repayment on July 31st, 2nd year for the issuer
Bond Payable 500,000
Discount 30,625
Cash 450,000
Gain on repayment 19,375
Remove the bond payable and the discount at the amount on the row of the repayment date. Bond payable is always at maturity value.
A. Determine the market rate at the date of issuance and the original price of the bond.
B. Prepare the amortization schedule for the bond for the first 3 payments
C. Record the bond issuance and the first 2 interest payments for the issuer and the investor.
D. Record the entry for the issuer and the investor given conversion of the bond occurs on June 1st of the second year.
Answer
A. A premium occurs when more cash is received than maturity value. The effective rate must be lower than the stated rate to receive more cash, therefore, the market/effective yield was 10%.
Go into the present value tables for 20 period and 5% (10 years x 2 & 10%/2)
| 100,000 x 12%/2 = 6,000 x 12.46221 = 74,773 100,000 x 0.37689 = 37,689 112,462 |
B. Amortization schedule:
Do the original date and payment dates first and then insert the other dates.
The other date row amounts are for the months that have passed since the last bond date divided by the months in the period x the next bond date row
| (10% / 2) Effective Interest % |
(MV x 12% / 2) Stated / Stated % |
|
|
End of Period Carrying Value |
|
| 1/1/y1 | 12,462 | 112,462 | |||
| 3/1/y1 (2/6) | 1,874 | 2,000 | 126 | 12,336 | 112,336 |
| 7/1/y1 | 5,623 | 6,000 | 377 | 12,085 | 112,085 |
| 10/31/y1 (4/6) | 3,736 | 4,000 | 264 | 11,821 | 111,821 |
| 1/1/y2 | 5,604 | 6,000 | 396 | 11,689 | 111,689 |
| 6/1/y2 (5/6) | 4,653 | 5,000 | 347 | 11,342 | 111,342 |
| 7/1/y2 | 5,584 | 6,000 | 416 | 11,273 | 111,273 |
C. Record the issuance and the first two interest payments.
Issuer:
| 3/1/y1 Cash 114,336 plug Premium 12,336 actual issue row Bond Payable 100,000 maturity value Interest Payable 2,000 stated column, actual row |
| 7/1/y1 Interest Payable 2,000 accrued before Interest Expense 3,749 (5,632 – 1,874) Premium 251 (377 – 126) Cash 6,000 full stated amount |
| 10/31/y1 Interest Expense 3,736 4 months row Premium 264 Interest Payable 4,000 |
| 1/1/y2 Interest Payable 4,000 accrued before Interest Expense 1,868 (5,604 – 3,736) Premium 132 (396 – 264) Cash 6,000 full stated amount |
Investor: Same amounts, opposite accounts
| 3/1/y1 Investment 112,336 Interest Receivable 2,000 Cash 114,336 |
| 7/1/y1 Cash 6,000 Interest Receivable 2,000 Interest Revenue 3,749 Investment 251 |
| 10/31/y1 Interest Receivable 4,000 Investment 264 Interest Revenue 3,736 |
| 1/1/y2 Cash 6,000 Interest Receivable 4,000 Interest Revenue 1,868 Investment 132 |
D. Record the conversion
Issuer
| Bond Payable 100,000 maturity value Premium 11,342 conversion date row Common Stock 4,000 par x number of shares issued Paid In Capital – CS 107,342 plug |
Investor
| Investment in Common Stock 111,342 Investment in Bond 111,342 |
Do not record a gain or loss on conversion.
A. Calculate the price of the bond on the actual issue date
B. Prepare an amortization schedule for the bond for the first 2 interest payments
C. Record the entry to issue the bonds for the company and the investor
D. Record the journal entry to accrue interest at year end for the company and the investor.
E. Record the journal entry for the second interest payment for the company and the investor.
Answer
A. Go into the present value tables for 14 periods and 4% (7 years x 2 & 8%/2)
| 1,000,000 x 10%/2 = 50,000 x 10.56312 = 528,156 1,000,000 x .57748 = 577,480 Full 7 years to maturity 1,105,636 less accrued cash 1 month (8,333) plus interest expense 1 month 7,371 Present value on actual issuance 1,104,674 |
Ignore the 7.5%, the bonds were not issued on September 1st.
You must present value cash flows at the effective rate on the actual issue date.
B. Amortization schedule:
| (8% / 2) Effective Interest % |
(MV x 10% / 2) Stated / Stated % |
|
|
End of Period Carrying Value |
||
| 9/1/y1 | 105,636 | 1,105,636 | ||||
| 9/30/y1 (1/6) | 7,371 | 8,333 | 962 | 104,674 | 1,104,674 | |
| 11/30/y1 (3/6) | 22,113 | 25,000 | 2,887 | 102,749 | 1,102,749 | investor y/e |
| 3/1/y2 | 44,225 | 50,000 | 5,775 | 99,861 | 1,099,861 | |
| 4/30/y2 (2/6) | 14,665 | 16,667 | 2,002 | 97,859 | 1,097,859 | issuer y/e |
| 9/1/y2 | 43,994 | 50,000 | 6,006 | 93,855 | 1,093,855 |
C. Issue the bonds:
Issuer
| 9/30/y1 Cash 1,113,007 Premium 104,674 Bond Payable 1,000,000 Interest Payable 8,333 |
Investor
| 9/30/y1 Investment 1,104,674 Interest Receivable 8,333 Cash 1,113,007 |
D. Record the accrual at year end – different year ends
Issuer – April 30th
| Interest Expense 14,665 Premium 2,002 Interest Payable 16,667 |
Investor – November 30th
| Interest Receivable 16,667 Investment 1,925 Interest Revenue 14,742 |
E. Record the 2nd Interest Payment on 9/1/y2
Issuer
| 9/1/y2 Interest Payable 16,667 Interest Expense 29,329 Premium 4,004 Cash 50,000 |
Investor
| 9/1/y2 Cash 50,000 Interest Revenue 43,994 Investment 6,006 |
Nothing was previously recorded during this 6-month period for the investor.