E14.
1 (LO 1) (Features of Long-Term Debt) The following examples describe possible
features or characteristics of long-term debt:
[Link] debt agreement includes a covenant that requires the debtor to maintain a minimum
amount of working capital.
[Link] stated rate of a bond issue is less than the market rate.
[Link] debt is backed by a claim on the debtor’s real estate.
[Link] debt agreement includes a covenant that limits the amount of additional debt that the
debtor can incur.
[Link] debt matures on a single date in 20 years.
[Link] bond gives the holder the right to convert the debt before maturity.
[Link] debtor arranges for defeasance of the debt.
[Link] debt is a debenture bond.
Instructions
a. Match each example in the preceding list to the number below that best describes it:
[Link] the riskiness of the long-term debt
[Link] the riskiness of the long-term debt
[Link] not affect the riskiness of the long-term debt
[Link] a feature or characteristic that increases the riskiness of the long-term debt, discuss the
effect of the feature or characteristic on investors’ required yield on the long-term debt.
Solution:
a.
1. 2
2. 3
3. 2
4. 2
5. 1
6. 2
7. 2
8. 1
b. A feature or characteristic that increases the riskiness of the long-term debt will cause
investors to require a higher yield on the long-term debt. A higher yield on the long-term debt
will give investors an acceptable return that matches the issuer’s risk characteristics.
E14.2 (LO 1, 2) (Information Related to Various Bond Issues) Anaconda Inc. has issued
three types of debt on January 1, 2023, the start of the company’s fiscal year:
1.$10 million, 10-year, 13% unsecured bonds, with interest payable quarterly, priced to yield
12%
2.$2.5 million par of 10-year, zero-coupon bonds at a price to yield 12% per year
3.$15 million, 10-year, 10% mortgage bonds, with interest payable annually to yield 12%
Instructions
Prepare a schedule that identifies the following items for each bond:
[Link] maturity value
[Link] number of interest periods over the life of the bond
[Link] stated rate for each interest period (round to two decimal places)
[Link] effective interest rate for each interest period (round to two decimal places)
[Link] payment amount per period
[Link] (1) factor tables, (2) a financial calculator, or (3) Excel function PV, calculate the present
value of the bonds at the date of issue. (Hint: Refer to Chapter 3 for tips on calculating.) Round
to the nearest dollar.
[Link] instrument has different features. Comment on how the instruments are different,
discussing the underlying nature of the debt. Which bonds are riskiest and why?
Solution:
Unsecured Bonds Zero-Coupon Bonds Mortgage Bonds
a. Maturity value $10,000,000 $2,500,000 $15,000,000
b. Number of 4 1 1
interest periods 0 0 0
c. Stated rate per 3.25% (13%/4 ) 0 10%
d. Effective rate 3% (12%/4 ) 12% 12%
e. Payment amount $325,000 (1) 0 $1,500,000 (2)
per period
f. Present value $10,577,900 (3) $804,925 (4) $13,304,880 (5)
(1) $10,000,000 X 13% X 1/4 = $325,000
(2) $15,000,000 X 10% = $1,500,000
3) Present value of an annuity of $325,000
discounted at 3% per period for 40
periods ($325,000 X 23.11477) = $ 7,512,300
Present value of $10,000,000 discounted
at 3% per period for 40 periods ($10,000,000 X .30656) = 3,065,600
$10,577,900
2. Using a financial calculator
3. Using Excel:= PV( rate, nper, pmt, fv, type)
1. Using factor tables
(4) Present value of $2,500,000 discounted at 12% for 10 periods ($2,500,000 X .32197) =
$804,925
2) Using a financial calculator:
1. Using factor tables
(5) Present value of an annuity of $1,500,000 discounted at 12% for 10 periods
($1,500,000 X 5.65022) = $8,475,330
Present value of $15,000,000 discounted at 12% for 10 years
($15,000,000 X .32197) 4,829,550
$13,304,880
2) Using a financial calculator:
A more accurate result is obtained using Excel or a financial calculator as compared to using
factors from tables as there are a limited number of decimal places in the tables.
g. Similarities and differences among the bond features and their impact on risk are as follows:
– bond maturity (duration) – The bonds all have the same maturity date (duration), thus this risk
factor is equalized among the bonds.
– bond stated rate and effective interest rate – The bonds all have a different stated interest rate
(ranging from a deep discount, zero-coupon bond of 0% to 13%). A discount on bonds payable
results when investors demand a rate of interest higher than the rate stated on the bonds. This
occurs when the investors are not satisfied with the stated nominal interest rate because they can
earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds
and cannot change the stated nominal rate. However, by lowering the amount paid for the bonds,
investors can alter the effective rate of interest. A premium on bonds payable results from the
opposite conditions. That is, when investors are satisfied with a rate of interest lower than the
rate stated on the bonds, they are willing to pay more than the face value of the bonds in order to
acquire them, thus reducing their effective rate of interest below the stated rate. In this case, all
the bonds are set to yield an effective interest rate of 12%, which adjusts the pricing of each
individual bond so that they are all equally attractive to investors (purely on interest rates).
– timing of cash flows – The bonds all have differing timing of cash flow to the investors. This
can affect their risk, as cash flows further in the future have a higher risk factor than cash flows
in the present.
– bond security – Bonds security affects the risk of the bond. In the event of default, a secured
bond will rank higher than an unsecured bond. Thus, unsecured bonds are generally riskier than
secured bonds. Presumably the mortgage bonds have security.
All the above factors have to be assessed together to determine the riskiness of each bond. The
zero-coupon bonds have no cash flows over the entire 10-year term, making them riskier in that
the company may not be able to pay back the $2.5 million at that time. On the other hand, the
zero-coupon bonds may have more security underlying them than the 13% bonds that are listed
as unsecured. The mortgage bonds are the least risky with the interest cash flows spread over the
life of the bonds, and with physical property pledged as collateral if Anaconda is unable to pay
the principal or interest. Further information is required, however, about the fair value of the
underlying collateral.
E14.4 (LO 2) (Entries for Bond Transactions—Effective Interest) Foreman Inc. issued
$800,000 of 10%, 20-year bonds on January 1, 2023, at 102. Interest is payable semi-
annually on July 1 and January 1. Foreman uses the effective interest method of
amortization for any bond premium or discount. Assume an effective yield of 9.75%. (With
a market rate of 9.75%, the issue price would be slightly higher. For simplicity, ignore
this.)
Instructions
Prepare the journal entries to record the following (round to the nearest dollar):
[Link] issuance of the bonds
[Link] payment of interest and the related amortization on July 1, 2023
[Link] accrual of interest and the related amortization on December 31, 2023
Solution:
a.
1/1/23 Cash ($800,000 X 102%)...................................................816,000
Bonds Payable............................................................816,000
b.
7/1/23 Interest Expense1..............................................................39,780
Bonds Payable..................................................................220
Cash2............................................................................40,000
1
($816,000 X 9.75% X 1/2)
2
($800,000 X 10% X 6/12)
c.
12/31/23 Interest Expense3..............................................................39,769
Bonds Payable..................................................................231
Interest Payable...........................................................40,000
3
($815,7804 X 9.75% X 1/2)
4
Carrying amount of bonds at July 1, 2023:
Carrying amount of bonds at January 1, 2023 $816,000
Amortization of bond premium
($40,000 – $39,780) (220)
Carrying amount of bonds at July 1, 2023 $815,780
E14.5 (LO 2) (Entries for Bond Transactions—Straight-Line) Foreman Inc. issued
$800,000 of 20-year, 10% bonds on January 1, 2023, at 102. Interest is payable semi-
annually on July 1 and January 1. The company follows ASPE and uses the straight-line
method of amortization for any bond premium or discount.
Instructions
[Link] the journal entries to record the following:
[Link] issuance of the bonds
[Link] payment of interest and the related amortization on July 1, 2023
[Link] accrual of interest and the related amortization on December 31, 2023
[Link] explain how the entries would change depending on whether Foreman follows IFRS or
ASPE.
Solution:
a.
(1) 1/1/23 Cash ($800,000 X 102%)...................................................816,000
Bonds Payable.............................................................816,000
(2) 7/1/23 Interest Expense...............................................................39,600
Bonds Payable1.................................................................400
Cash2............................................................................40,000
1($16,000 / 40)
2($800,000 X 10% X 6/12)
(3) 12/31/23 Interest Expense...............................................................39,600
Bonds Payable..................................................................400
Interest Payable...........................................................40,000
b. Although the effective interest method is required under IFRS per IFRS [Link], accounting
standards for private enterprises do not specify that this method must be used and therefore, the
straight-line method is also an option. The straight-line method is valued for its simplicity and
might be used by companies reporting under ASPE.
E14.6 (LO 2) (Entries for Non–Interest-Bearing Debt) On January 1, 2023, Landlord
Corporation acquired the following properties:
[Link] property consisting of land and an apartment building in Toronto for $1.5 million.
To finance this transaction, Landlord issued a five-year interest-free promissory note to repay
$2,307,941 on January 1, 2028.
[Link] land in Rome, Italy, for $2 million. To finance this transaction, Landlord obtained a 7%
mortgage for the full purchase price, secured by the land, with a maturity date of January 1,
2033. Interest is payable annually. If Landlord borrowed this money from the bank, the company
would need to pay 9% interest.
Instructions
[Link] (1) factor tables, (2) a financial calculator, or (3) Excel function PV, calculate the value
of the mortgage. Using the calculation from the tables, record Landlord’s journal entries on
January 1, 2023, for each of the purchases. (Hint: Refer to Chapter 3 for tips on calculating.)
[Link] the interest at the end of the first year on both instruments using the effective interest
method.
Solution:
a. January 1, 2023
1. Investment Property.........................................................1,500,000
Notes Payable..........................................................1,500,000
(The $1,500,000 capitalized cost represents the present value of the note with maturity amount of
$2,307,941 discounted for five years at 9%)
2. Land...................................................................................1,743,292
Mortgage Payable....................................................1,743,292
1. Using tables:
Present value of $2,000,000 due in10 years at 9%
—$2,000,000× .42241 $844,820
Present value of $140,000 ($2,000,000 X 7%)
payable annually for 10 years at 9% annually
—$140,000× 6.41766 898,472
Present value of the note $ 1,743,292
Discount to be amortized $ 256,708
2. Using a financial calculator: - for the principal
A more accurate result is obtained using Excel or a financial calculator as compared to using
factors from tables as there are a limited number of decimal places in the tables. This difference
in most cases is immaterial.
b.
1. Interest Expense ($1,500,000 X .09)................................135,000
Notes Payable..........................................................135,000
2. Interest Expense ($1,743,292 X .09)................................156,896
Mortgage Payable.................................................... 16,896
Cash ($2,000,000 X .07)...........................................140,000
E14.11 (LO 2) (Entries for Bond Transactions) On January 1, 2023, Osborn Inc. sold 12%
bonds having a maturity value of $800,000 for $860,652, which provides the bondholders
with a 10% yield. The bonds are dated January 1, 2023, and mature on January 1, 2028,
with interest payable on January 1 of each year. The company follows IFRS and uses the
effective interest method. Round calculations to the nearest dollar.
Instructions
[Link] the journal entry at the date of issue.
[Link] a schedule of interest expense and bond amortization for 2023 through 2026.
[Link] the journal entries to record the interest payment and the amortization for 2023.
[Link] the journal entries to record the interest payment and the amortization for 2025.
[Link] Osborn prepares financial statements in accordance with ASPE, can Osborn choose a
different method of amortizing any premium or discount on its bonds payable? Explain your
answer.
Solution:
a. January 1, 2023
Cash ...................................................................................860,652
Bonds Payable......................................................... 860,652
c. December 31, 2023
Interest Expense...............................................................86,065
Bonds Payable..................................................................9,935
Interest Payable.......................................................96,000
January 1, 2024
Interest Payable................................................................96,000
Cash..........................................................................96,000
d. December 31, 2025
Interest Expense...............................................................83,979
Bonds Payable..................................................................12,021
Interest Payable.......................................................96,000
January 1, 2026
Interest Payable................................................................96,000
Cash..........................................................................96,000
e. Accounting standards for private enterprises do not specify that the effective interest method
must be used an therefore the straight-line method is also an option. Osborn may prefer to use the
straight-line method due to its simplicity. However, the effective interest method is required
under IFRS per IFRS [Link].
E14.13 (LO 2) (Amortization Schedule—Effective Interest) Minor Inc. sells 10% bonds
having a maturity value of $3 million for $2,783,713. The bonds are dated January 1, 2023,
and mature on January 1, 2028. Interest is payable annually on January 1.
Instructions
Set up a schedule of interest expense and discount amortization under the effective interest
method. Round calculations to the nearest dollar. (Hint: The effective interest rate must be
calculated using (1) a financial calculator or (2) Excel function Rate. Refer to Chapter 3 for tips
on calculating.)
Which method of discount amortization results in higher interest expense for the year ended
December 31, 2023? Which method of discount amortization results in higher interest expense
for the year ended December 31, 2027? Explain the results. From the perspective of a user of
Minor’s financial statements, which method would you prefer the company to use, if you would
like the company’s income statement to reflect the most faithfully representative measure of net
income?
Solution:
b. The straight-line method results in higher interest expense for the year ended December 31,
2023, and the effective interest method results in higher interest expense for the year ended
December 31, 2027. Under the straight-line method, the amount that is amortized each year is
constant. Under the effective interest method, the amount amortized each year is based on a
constant percentage of the bonds’ increasing carrying amount. Users who like the company’s
income statement to reflect the most faithfully representative measure of net income would
prefer that the company use the effective interest method, under which interest expense
correlates more closely with the actual carrying amount of the bond.
E14.20 (LO 3) (Entry for Retirement of Bond; Costs for Bond Issuance) On January 2,
2018, Kowalchuk Corporation, a small company that follows ASPE, issued $1.5 million of
10% bonds at 97 due on December 31, 2027. Legal and other costs of $110,000 were
incurred in connection with the issue. Kowalchuk has a policy of capitalizing and
amortizing the legal and other costs incurred by including them with the bond recorded at
the date of issuance. Interest on the bonds is payable each December 31. The $110,000 of
issuance costs are being deferred and amortized on a straight-line basis over the 10-year
term of the bonds. The discount on the bonds is also being amortized on a straight-line
basis over the 10 years. (The straight-line method is not materially different in its effect
compared with the effective interest method.)
The bonds are callable at 102 (that is, at 102% of their face amount), and on January 2, 2023, the
company called a face amount of $850,000 of the bonds and retired them.
Instructions
Ignoring income taxes, calculate the amount of loss, if any, that the company needs to recognize
as a result of retiring $850,000 of bonds in 2023. Prepare the journal entry to record the
retirement. Round to the nearest dollar.
How would the amount of the loss calculated in part (a) differ if Kowalchuk’s policy had been to
carry the bonds at fair value and thus expense the costs of issuing the bonds at January 2, 2018?
Assuming that Kowalchuk had followed this policy, prepare the journal entry to record the
retirement. Assume the redemption price approximates fair value.
How would your answers to parts (a) and (b) change if Kowalchuk followed IFRS?
Solution:
[Link] price ($850,000 X 102%) $867,000
Less: Net carrying amount of bonds redeemed:
Par value 850,000
Unamortized discount1 (43,917)
806,083
Loss on redemption $ 60,917
1
Calculation of unamortized discount—
Original amount of discount:
$850,000 X 3% = $25,500 $25,500
Bond issuance costs ($110,000 X
$850,000/$1,500,000 = 62,333
Amount to be amortized over 10 years $87,833
Amount of discount unamortized:
1
($87,833 X 5) ÷ 10 = $43,917
January 2, 2023
Bonds Payable..................................................................806,083
Loss on Redemption of Bonds .......................................60,917
Cash.......................................................................... 867,000
b. Had the costs of issuing the bond of $110,000 been expensed on the date of issue (which is the
required accounting treatment for transactions costs when the debt is subsequently measured at
fair value rather than amortized cost), the issue costs would have been charged to expense in
2018.
Reacquisition price ($850,000 X 102%) $867,000
Less: Carrying amount of bonds on the
reacquisition date = fair value at that date (see
assumption) （867,000）
Gain/Loss on redemption $ -0
c. If Kowalchuk were to follow IFRS, then the effective interest method must be used to
amortize any discounts or premiums. Although the effective interest method is required under
IFRS per IFRS [Link], accounting standards for private enterprises do not specify that this
method must be used and therefore, the straight-line method is also an option. The straight-line
method is valued for its simplicity and might be used by companies whose financial statements
are not constrained by IFRS.
Under IAS 39, where the fair value option is selected, credit risk is incorporated into the
measurement and resulting gains/losses are booked through net income. However, under IFRS 9,
gains/losses related to changes in credit risk are booked through Other Comprehensive Income.
(Note that under ASPE, where the fair value option is used, credit risk is incorporated into the
measurement and resulting gains/losses are booked through net income.)