Bonds Payable and Other Long-term Liabilities

Hard Practice Test

Introduction to Accounting

Hard Practice Test

Click the “Check Your Answer” box below each question 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 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. The company can raise the same amount of capital from issuing stock or bonds (d).

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 rate 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 market 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 market 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.

11. On May 1, 20X0, the Company issued a $500,000, 8%, 5-year bond for $461,834. Interest will be paid on May 1st and November 1st of each year. The market rate on the date of issue was 10%. The market rate at the end of the 1st year and 2nd year was 11% and 11.5% respectively. The company has the option to pay back the bonds early at the end of the 2nd year at a price of $450,000. Fair market value of the bond is $600,000 at the end of the 2nd year.

A. Prepare the amortization schedule for the bond for the first 3 payments
B. Record the issuance of the bond and the third interest payment made.
C. Should the company repay the bond at the end of the 2nd year?
D. What is the total interest expense that should be reported on the income statement for the year 20X0?

Answer

Market rate changes after the bond is issued have no impact on the company.

A. (10% / 2)
Effective
Interest %

(MV x 8% /2)
Stated %


Difference


Premium /
Discount

Carrying
Value
5/1 38,166 461,834
11/1 23,092 20,000 3,092 35,074 464,926
5/1 23,246 20,000 3,246 31,828 468,172
11/1 23,409 20,000 3,409 28,419 471,581
B.            Cash                         461,834
                Discount                   38,166
                        Bond Payable                   500,000
               Interest Expense             23,409
                         Discount                              3,409
                         Cash                                   20,000

C. The bond can be repaid for $450,000. Fair market value is now $600,000. When the value of the bond goes up, interest rates are lower. The current amount owed is not relevant to the decision to refinance. It is not the amount that would be paid to the holder of the bond. The company should also consider that they will pay $11,834 less to repay the bond than was received. This will be recorded as a gain on the income statement. The company should consider paying this bond off and borrowing at a lower interest rate.

D. Interest expenses reported for 20X0 should be the amount incurred during 20X0:

May 1 to October 31st 		   23,092
November 1 to December 31	     7,749	
    Total interest expense		   30,841

(23,246 x 2 / 6-month period) = $7,749

The amount from November 1 to December 31 has not yet been paid, and must be accrued as interest expense.

12. On January 1, 20X0, the company issued $100,000, 12%, 10-year bonds at a price of $112,463. The market rate of interest was either 10% or 14%; the company accountant can not find the documentation to determine the effective rate. Interest is paid semiannually on January 1 and July 1. The market rate of interest increased after the bonds were issued.

A. Determine the market rate at the date of issuance.
B. Prepare the amortization schedule for the bond for the first 3 payments
C. Record the bond issuance and the first 2 interest payments.
D. What will be reported on the balance sheet dated December 31, 20X0?
E. What will be reported on the 20X0 income statement?
F. Record the entry for early repayment of the bond on June 1, 20X1 for $105,000.

Answer

A. When more cash is received than maturity value, a premium, the effective rate must be lower than the stated rate, therefore, the market rate was 10%. Interest changes after the bond is issued do not change the amortization schedule or affect the company.

B. Amortization schedule:

        (10% / 2)        
	    Effective	        (MV x 12% / 2)                                 Premium/         Carrying
	    Interest %	     Stated %	   Difference	    Discount	       Value

1/1/X0							                     12,463		112,463
7/1/X0   5,623                   6,000       	      377		12,086		112,086
1/1/X1     5,604                   6,000                   396                11,690	    111,690
7/1/X1     5,585                        6,000                        415                11,275             111,275

C.

Cash			112,463
	Premium		      12,463
	Bond Payable	    100,000


Interest Expense	5,623
Premium		       377
	Cash		     6,000

Interest Expense	 5,604
Premium		        396
	Cash			 6,000

D. $111,690 will be the net bond payable reported on the December 31st, 20X0 balance sheet. The carrying value column always shows the amount owed.

E. Interest expense will be the total of the 2, 6-month periods during 20X0.

5,623 + 5,604 = 11,227

F. This is an early repayment of the bond which will lead to a gain or loss. When more is paid than owed, a loss is recorded. When less is paid than owed, a gain is recorded.

Decrease the bond payable and the premium to get them to 0 (nothing is owed).
Record the cash paid as a decrease
Plug the difference to a gain or loss

Bond Payable		   100,000
Premium			     11,275
	Cash			     105,000
	Gain on early repayment        6,275