Bonds
Medium Practice Test
Intermediate Accounting 2
Medium Practice Test
Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.
1. When the effective yield is higher than the stated rate, the bond will be sold at
a. a discount
b. a premium
c. par
d. maturity value
Answer
A. To get a higher effective yield, a lower amount must be invested. When the investor gives the company an amount lower than maturity value it is a discount. Because the annual cash received (stated interest rate x maturity value) from the bond will not change, a lower investment gives a higher return and a higher investment gives a lower return.
2. When a bond is issued at a premium, the stated rate will be
a. equal to the effective rate
b. lower than the effective rate
c. higher than the effective rate
d. a rate that changes with changes in the market rate
Answer
C. A premium occurs when the company receives more than maturity value when the bond is issued. When more is received, the effective interest rate is lower than the stated interest rate (so stated is higher). The effective rate always moves the opposite direction from the cash received.
3. When a bond is issued at a discount, interest expense will be
a. higher than the amount of cash paid for interest
b. lower than the amount of cash paid for interest
c. equal to the amount of cash paid for interest
d. lower than the market rate of interest
Answer
A. The company receives less than maturity value when a bond is issued at a discount. When less is received, interest expense (effective interest rate) is higher than the cash paid (stated interest rate).
4. A company issues a $200,000, 6%, 5-year bond for a price of 98. The total amount of interest expense that will be recorded by the company over the life of the bond is
a. $64,000
b. $56,000
c. $204,000
d. $196,000
Answer
A. The amount paid for interest is always the maturity value x the stated rate. A discount represents additional interest expense over the life of the bond. A premium represents lower interest expense over the life of the bond. Total interest expense is computed as:
| maturity value x stated % = per year x years = interest paid (also an expense) $200,000 x .06 + $12,000 x 5 = $60,000 + additional interest expense not paid until maturity $ 4,000 the discount Total interest expense $64,000 |
5. When recording interest related to bonds payable, the company will use the amortization schedule to
a. determine the maturity value of the bond at the end of the period
b. determine the cash interest that will be paid
c. determine the effective interest rate for the period
d. determine the difference in interest expense and cash paid
Answer
D. The amortization schedule determines the interest expense for the period. Interest expense is computed by multiplying the amount owed at the beginning of the period by the effective market rate. Cash paid for interest is stated in the contract and does not change. The difference in the interest expense and the cash paid for interest will increase or decrease the net amount owed (carrying amount). (a. & b.) are stated in the bond contract and do not change. The effective interest rate is known at the time the bond is issued and is not determined by the amortization schedule (c).
6. The investor pays for accrued interest when the actual issuance date is not the same as the original bond issuance date because
a. the issuer has earned the interest
b. the investor has earned the interest and will be repaid with the first interest payment
c. the investor has not earned the interest and will be paid the full stated interest payment on the payment date
d. the investor has incurred the interest and must pay the incurred amount
Answer
C. The issuer must always pay the full stated amount on the interest payment date. Because the funds were not loaned to the issuer at the beginning of the period, the investor has not earned the full amount they receive. When the investor pays the part that is not earned and receives the full amount, the net amount received is equal to the amount that is actually earned by the investor.
7. Early redemption requires the issuer to
a. repay the bond payable for the maturity value on the maturity date
b. repay the bond payable for the net amount owed on the redemption date
c. repay the bond payable for the amount specified in the bond contract
d. none of the above
Answer
C. Early redemption means the issuer repays the bond payable prior to maturity in accordance with the terms stated in the original bond contract. This is typically done at the option of the issuer.
8. The entry to record the issuance of a bond will
a. decrease assets and increase liabilities
b. increase assets and increase liabilities
c. increase interest expense, assets, and liabilities
d. decrease liabilities and assets
Answer
B. Issuing a bond is just borrowing money. Cash is increased and bonds payable is increased also. Cash is an asset and bonds payable is a liability. Interest is not recorded until time passes (c.).
9. When bonds are issued at a discount, the amount reported on the balance sheet as bonds payable is
a. higher than maturity value
b. lower than maturity value
c. always equal to maturity regardless of the issue price
d. always equal to par regardless of the issue price
Answer
B. A discount occurs when the amount of cash received is lower than maturity value. During the years the bond is outstanding, the net amount owed will be lower than maturity value. Bonds payable is reported on the balance sheet at a net amount; maturity value plus the premium or maturity value less the discount.
10. When bonds are issued at a premium, total interest expense incurred over the life of the bond will
a. be equal to the maturity value of the bond
b. be less than cash paid for interest over the life of the bond
c. be more than cash paid for interest over the life of the bond
d. be equal to cash paid for interest over the life of the bond
Answer
B. The additional amount received (premium) is also the amount that interest expense is less than cash paid for interest. When the company receives more than they have to repay at the end of the term, effective interest is less.
A. Compute the price of the bond on the original issue date
B. Prepare an amortization schedule for the first 3 periods
C. Prepare the required journal entry for issuing the bonds for the issuer and investor
D. Prepare the required journal entry on June 30th of the first year for the issuer and the investor.
Answer
A. Compute the price of the bond:
| 25,000 | x 13.59033 | = 339,758 |
| 500,000 | x .45639 | = 228,195 |
| 567,953 |
B. Amortization Schedule
Do the bond schedule 1st; original date and payment dates
Then add the rows for the other dates.
Multiply the time passed by the amount on the next row.
| (8% / 2) Effective Interest % |
(MV x 10%/2) Stated % |
|
|
End of year Carrying Value |
|
| 1/1/y1 | 67,953 | 567,953 | |||
| 4/1 (3/6) | 11,359 | 12,500 | 1,141 | 66,812 | 566,812 |
| 6/30/y1 | 22,718 | 25,000 | 2,282 | 65,671 | 565,671 |
| 12/31/y1 | 22,627 | 25,000 | 2,373 | 63,298 | 563,298 |
| 6/30/y2 | 22,532 | 25,000 | 2,468 | 60,830 | 560,830 |
C. Issuance of the bond for issuer and investor:
|
Issuer Investor: Cash 579,312 Investment 566,812 |
Note:
The payable/receivable is for the amount in the stated column on that date.
No interest expense/revenue on the issue date
The premium is for the amount in the row on the issue date
Bonds payable is always at maturity value
Cash is the plug that makes the journal entry balance
D. Interest payment date on June 30th of the first year:
|
Issuer Investor: Interest Payable 12,500 Cash 25,000 |
Note:
Cash paid/received is always for the full stated amount.
Interest payable/receivable is for the amount that was previously accrued
Interest expense is for the time that has passed since the last entry
3 months = 6 months 22,718 less 3 months 11,359
Premium/Investment is for 3 months, time since last journal entry
3 months = 6 months 2,282 less 3 months 1,141
A. Determine the amount of cash exchanged when the bonds were issued.
B. Determine the amount of the discount/premium when the bonds were issued.
C. Determine the first years’ interest expense
D. Determine total interest expense over the life of the bonds
E. Determine the total amount of cash that will be paid for interest over the life of the bond.
F. Determine the amount that will be repaid on the maturity date.
G. Determine the amount that will be reported on the balance sheet at the end of the year the bond was issued.
Answer
A. Cash exchanged is computed:
| Maturity Value | 250,000 |
| x price of bond as a % | 0.971 |
| = Cash exchanged | 242,750 |
B. A discount occurs when the cash exchanged is less than maturity value for the difference:
| Cash exchanged | 242,750 |
| Maturity value | 250,000 |
| Discount | 7,250 |
C. The first period interest expense will be the cash exchanged x the effective rate. The new amount owed (carrying value) must be determined for the second period:
|
242,750 x .07 / 2 = 8,496 1st 6 months ** 250,000 x 0.06 / 2 = 7,500 cash paid each period |
D. Total interest expense over the life of the bond is
| Cash paid (250,000 x 6% / 2) | 7,500 |
| x number of payments per year | x 2 |
| x years to maturity | 10 |
| = total cash paid | 150,000 |
| + discount added to interest exp | 7,250 |
| = total interest expense | 157,250 |
E. The cash paid over the life of the bond is 150,000, computed in D.
F. The amount that is repaid on the maturity date is the maturity value, $250,000
G. The amount that will be reported on the balance sheet is the amount of the carrying value on that date:
| Cash received | 242,750 |
| – Cash paid for the year (7,500 x 2) | (15,000) |
| + interest expense for the year (c.) | 17,027 |
| = adjusted amount owed end of year | 244,777 |
| reported on Balance Sheet |
A. Calculate the price of the bond on the issue date.
B. Prepare an amortization schedule for the first 3 payment dates
C. Record the journal entry to issue the bonds for the issuer and the investor
D. Record the journal entry for the issuer and investor for the 1st payment date.
E. Accrue interest at year end of the current year for the issuer and the investor
F. What will be reported on the financial statements at the end of year 1 (1/31/y2) relative to the bonds for the issuer?
Answer
A. Compute the price of the bond:
| 800,000 x 6%/2 = | |
| 24,000 x 8.75206 = | 210,049 |
| 800,000 x .78120 = | 624,960 |
| 835,009 |
B. Amortization Schedule
Do the bond schedule 1st; original date and payment dates
Then add the rows for other dates.
Multiply the time passed by the amount on the next row.
| (5% / 2) Effective Interest % |
(MV x 6%/2) Stated % |
|
|
End of year Carrying Value |
|
| 2/1/y1 | 35,009 | 835,009 | |||
| 4/30 (3/6) | 10,437 | 12,000 | 1,563 | 33,446 | 833,446 |
| 8/1/y1 | 20,875 | 24,000 | 3,125 | 31,884 | 831,884 |
| 2/1/y2 | 20,797 | 24,000 | 3,203 | 28,681 | 828,681 |
| 8/1/y2 | 22,532 | 25,000 | 2,468 | 26,213 | 826,213 |
C. Issuance of the bond for issuer and investor:
|
Issuer Investor: Cash 845,446 Investment 833,446 |
Note:
The payable/receivable is for the amount in the stated column on the actual issue date row
No interest expense/revenue on the issue date
The premium is for the amount in the row on the issue date
Bonds payable is always at maturity value
Cash is the plug that makes the journal entry balance
D. Interest is paid: interest payment date is August 1st of the first year:
|
Issuer Investor: Interest Payable 12,000 Cash 25,000 |
Note:
Interest payable/receivable is for the amount that was previously accrued
Interest expense is for the time that has passed since the last entry
3 months = 6 months 20,875 less 3 months 10,437
Premium/Investment is for 3 months, time since last journal entry
3 months = 6 months 3,125 less 3 months 1,563
E. Accrue Interest, first year end after issuance
(1/31 is one day less than the full 6-month period, so use the 2/1 row)
|
Issuer Investor Interest Expense 20,797 Interest Receivable 24,000 |
F. Report on the Financial Statements at the end of the first year
| Bond Payable | 800,000 |
| Premium | 28,681 |
| Bond Payable reported | 828,681 |
| Interest expense – 3 months | 10,438 |
| Interest expense – 6 months | 20,797 |
| Total interest expense reported: | 31,235 |