Bonds

Easy Practice Test

Intermediate Accounting 2

Key Things To Know

j

Practice As You Learn

Self Test

b

Easy Practice Test

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Medium Practice Test

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Hard Practice Test

Easy Practice Test

Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.

1. When a company issues a bond, a contract (indenture) is prepared which states all of the following except:

a. the stated interest rate
b. the market interest rate
c. maturity value
d. maturity date

Answer
B. The market interest rate is based on economic factors and company specific risk. All other items are stated in the bond contract and will not change.
2. Bonds payable is usually classified and reported on the balance sheet as

a. a long-term liability at maturity value
b. a long-term liability at present value of the amount owed
c. a long-term liability at the future value of the amount owed
d. a long-term liability at maturity value plus a discount.

Answer
B. Bonds payable are repaid at maturity which is almost always longer than one year. They are reported at the present value of the amount owed (future cash flows).
3. The entry made to record effective interest incurred will

a. decrease interest expense
b. increase interest expense
c. decrease cash
d. decrease bonds payable

Answer
B. Interest incurred is always an increase to interest expense. The amount that cash is decreased is determined by the stated rate (c.). Bonds payable remains at maturity value.
4. On the maturity date, the company will

a. record the total interest expense related to the bond
b. record the discount or premium on the bond
c. repay the maturity value to the investor
d. repay the principle plus all interest incurred on the bond

Answer
C. The maturity date is the date the maturity value is repaid. Maturity value is the amount that is owed to the investor. (b.) is done when the bond is issued. Interest is paid as it is incurred each period (d). Total interest expense is recorded over the life of the bond as it is incurred (a.)
5. The company issuing the bond will receive less than face value if

a. the stated rate is equal to the market rate
b. the stated rate is less than the market rate
c. the stated rate is more than the market rate
d. par value is not equal to face value

Answer
B. The amount of cash received annually is always the same (the stated). When a lower amount is invested, the % return is higher. When a higher amount is invested, the % return is lower. The return is the market rate. Par value and face value are both words that mean the same as maturity value (d). When (a) occurs, the maturity value is equal to cash exchanged. 
6. A company issued a 100,000, 8%, 5-year bond. The cash exchanged on the date of issue was $104,000. The total amount of interest the company will pay is

a. $8,000
b. $41,600
c. $40,000
d. $44,000

Answer
C. The amount of annual interest paid is always equal to the maturity value times the stated interest rate. 100,000 x 8% = 8,000 each year x 5 years = $40,000. The rate stated is always an annual rate. Cash exchanged does not change the amount of cash paid for interest.
7. A company issued an $80,000, 10% 10-year bond at a price of 104 when the market rate of interest was 9%. The amount of cash received by the company at issuance is

a. $80,000
b. $72,000
c. $83,200
d. $88,000

Answer
C. The price of the bond determines the amount of cash exchanged. 104 means that the bond was issued at 104% of maturity value. Cash received is $80,000 maturity value x 1.04 = $83,200. 
8. The definition of premium or discount is

a. the difference in cash received and the bond price
b. the difference in cash received and the effective interest rate
c. the difference in cash received and the maturity value of the bond
d. the amount of cash received form issuing the bond

Answer
C. The difference in the maturity value and the cash exchanged on the issue date is a premium or discount. When cash exchanged is higher than MV it is a premium. When cash exchanged is lower than MV it is a discount. Cash received is equal to the bond price (a.)
9. A company issued a $150,000 bond with a stated interest rate of 6% when the effective market yield is 8%. The amount of cash the company received is

a. $150,000
b. less than $150,000
c. more than $150,000
d. $21,000

Answer
B. A market rate higher than the stated rate means the investor gives less than maturity value. The cash interest received from the bond is the same every year, so to get a higher return the investor must invest less. 
10. The issuer must record accrued interest when

a. the bond is not actually issued on the original issue date
b. the bond is actually issued on the original issue date
c. their year end is not on a bond payment date
d. both a. and c.

Answer
D. The issuer must record the accrued interest for the time that passes between the original issue date and the actual issue date. The investor pays for this interest and the issuer repays this interest with the first payment of interest. Accrued interest must also be recorded at year end.
Remember:

Maturity date is when the borrowing is repaid
Maturity value is the amount that is repaid at maturity

Discount – less cash received than maturity value,
The effective rate is higher than stated rate.
Interest expense is higher than cash paid

Premium – more cash received than maturity value
The effective rate is lower than stated rate.
Interest expense is lower than cash paid

Stated rate = cash paid
Effective market rate = interest expense

11. The company issued 100,000, 5 year, 8% bonds at par at the beginning of the current year. Interest is paid on December 31st and June 30th.

A. Prepare the amortization schedule for the bond for the first two payments.
B. Record the issuance of the bond and the first and second interest payments for the company issuing the bonds.

Answer
8%/2=4%
Effective
Interest %		 8%/2=4%
Stated /
Stated %


Difference
Premium/
Discount		 End of period
Carrying
Value
1/1 100,000
6/30 4,000 4,000 0 0 100,000
12/31 4,000 4,000 0 0 100,000


B. Issue the bond:
Cash                            100,000
           Bond Payable             100,000

The same journal entry is used for all payments

Interest Expense                4,000
           Cash                                      4,000

Par value = no discount or premium
There is no difference in the interest expense incurred (market/effective) and the cash paid for interest (stated)

12. The company issued a 10%, 10-year bond with a face value of $100,000 for $113,592 on January 1st of the current year. The market rate of interest at the time of issuance was 8%. Interest is paid on December 31st and June 30th.

A. Prepare the amortization schedule for the bond
B. Record the issuance of the bond and first and second interest payments for the issuer.
C. What is the amount of bonds payable that will be reported on the balance sheet at the end of the first year
D. What is the total interest expense that will be reported for the first year?

Answer

A. $100,000 x .10 / 2 each year = $5,000 always in the stated column

The amount that goes in the effective interest column is computed as:
Prior period carrying value amount x market % / # payments each yr

The premium at issuance = cash received (bond price) less maturity value

The carrying value (amount owed) column always starts with the cash exchanged

8%/2=4%
Effective
Interest %		 10%/2=5%
Stated /
Stated %


Difference

Premium
Carrying
Value
1/1 13,592 113,592
6/30 4,544 5,000 456 13,136 113,136
12/31 4,525 5,000 475 12,661 112,661

B. Issue the bond:

Cash                          113,592
          Bond Payable           100,000
          Premium                     13,592

First and second interest payments: same journal entry, different numbers

1st
Interest Expense                4,544
Premium                                456
               Cash                                5,000

2nd
Interest Expense                 4,525
Premium                                 475
             Cash                                   5,000

C. The amount in the carrying value column is the amount that will be reported for the net bonds payable on the balance sheet. $112,661 will be reported at the end of the 1st year. Companies do not report the premium separate. The amount reported is the maturity value plus the premium.

D. Total interest expense for the year is the first period plus the second period.
The two six-month periods are equal to the full year interest expense incurred.

4,544 + 4,525 = 9,069 interest expense for the first year

13. The company issued a 10%, 5-year bond with a face value of $200,000 for $192,608 on the original issue date. The market rate of interest at the time of issuance was 11%. Interest is paid annually on January 1st. Year end is December 31st.

A. Prepare the amortization schedule for the bond
B. Record the first and second interest payments for the issuer.
C. What is the amount of bonds payable that will be reported on the balance sheet at the end of the second year.
D. What is the total amount of cash that will be paid for interest over the life of the bond?
E. What is the total amount of interest expense that will be recorded over the life of the bond?

Answer

A.
$200,000 x 10% / 1 each year = $20,000 always in the stated column

The amount that goes in the effective interest column is computed:

Prior period carrying value amount x market % / # payments each yr

The discount = maturity value – cash received (bond price)

The carrying value (amount owed) column always starts with the cash exchanged

(11% / 1)
Effective
Interest %		 (10 % / 1)
Stated /
Stated %


Difference


Discount

 End of Year
Carrying
Value
1/1/y1 7,392 192,608
1/1/y2 21,187 20,000 1,187 6,205 193,795
1/1/y3 21,317 20,000 1,317 4,888 195,112

B. Issue the bond on 1/1y1:

                   Issuer:

Cash                         192,608
Discount                      7,392
           Bond Payable          200,000

First and second interest payments – the same journal entry, different numbers

1st 12/31:

Interest Expense         21,187
          Discount                            1,187
          Interest payable            20,000

1/1/y2
Interest Payable         20,000
           Cash                            20,000

2nd 12/31
Interest Expense           21,317
          Discount                            1,317
          Interest payable             20,000

1/1y3
Interest Payable          20,000
           Cash                             20,000

Interest is accrued on 12/31 because interest was incurred during the period ended 12/31. It is paid the next day, January 1st.

Investor:

Investment           192,608
          Cash                       192,608

First and second interest payments – the same journal entry, different numbers

1st 12/31
Interest Receivable    20,000
Investment                    1,187
          Interest Revenue        21,187

1/1/y2
Cash                                  20,000
          Interest Receivable          20,000

2nd 12/31
Interest Receivable             20,000
Investment                             1,317
           Interest Revenue               21,317

1/1y3
Cash                                     20,000
           Interest Receivable           20,000

Interest is accrued on 12/31 because interest was earned during the period ended 12/31 and interest is paid on January 1st.

C. On the balance sheet at the end of the 2nd year:
Carrying value at the end of the second annual payment period: 195,112

D. Total amount of cash paid is equal to annual interest paid x number of years:
$20,000 paid each year x 5 years = $100,000 total cash paid

E. Interest expense for the life of the bond is total cash paid plus the discount. A discount means that interest incurred is higher than cash paid.

 

Cash Paid each year 20,000
x # of years x          5
Total cash paid 100,000
+ discount      7,392
Total interest expense 107,392
14. The company issued a 10%, 5-year bond with a face value of $200,000 for $192,608 on March 1st. The market rate of interest at the time of issuance was 11%. Interest is paid annually on December 31st. The bond matures on December 31st.

A. Prepare the amortization schedule for the bond (same as problem 13., add rows)
B. Record the issuance of the bond for the issuer and the investor.
C. Record the first interest payment for the issuer.
D. Record the first interest payment for the investor.
E. Record the early repayment of the bonds on July 31st of the 3rd year for $190,000
for the issuer and the investor.

Answer

A. Amortization schedule:

(11% / 1)
Effective
Interest %		 (10 % / 1)
Stated /
Stated %


Difference
Premium/
Discount		 End of Year
Carrying
Value
1/1/y1 7,392 192,608
3/1 (2/12) 3,531 3,333 198 7,194 192,806
12/31/y1 21,187 20,000 1,187 6,205 193,795
12/31/y2 21,317 20,000 1,317 4,888 195,112
7/31/y3 12,520 11,667 853 4,035 195,965
(7/12)
12/31/y3 21,462 20,000 1,462 3,426 196,574


B. Issuance of the bond on March 1st

                      Issuer                                                                    Investor:

Discount                                  7,194                        Investment                                192,806
Cash                                    196,139                        Interest Receivable                      3,333
          Interest Payable                        3,333                          Cash                                          196,139
          Bonds Payable                      200,000


C. 1st Interest Payment for the Issuer:

Interest Expense                        17,656                                (21,187 – 3,531)
Interest Payable                           3,333                                accrued at issuance
               Cash                                        20,000                      always the full stated
               Discount                                      989                        (1,187 – 198)

Record amounts for the 10-month period.

D. 1st Interest Payment for the Investor (same amounts as the issuer, opposite accts)

Investment                                        989
Cash                                              20,000
            Interest Receivable                   3,333
            Interest Revenue                    17,656

E. Early repayment of the bond:

You must insert a row for the repayment date. The row is for 7/12th of the next payment date row because 7 months of the 12-month period has passed.

                           Issuer                                           Investor

Bond Payable                200,000                          Loss on Repayment                5,965
           Discount                              4,035              Cash                                      190,000
           Cash                                 190,000                         Investment                               190,965
           Gain on Repayment           5,965

Plug to gain or loss to make the entry balance.