Problem 20 - Accounting

Question

On the first day of its fiscal year, Simon Company issued \(25,000,000 of 10-year, 10% bonds to finance its operations of producing and selling video equipment. Interest is payable semiannually. The bonds were issued at an effective interest rate of 13%, resulting in Simon Company receiving cash of \)20,868,138. a. Journalize the entries to record the following: 1\. Sale of the bonds. 2\. First semiannual interest payment, including amortization of discount. 3\. Second semiannual interest payment, including amortization of discount. b. Compute the amount of the bond interest expense for the first year.

Step-by-Step Solution

Answer

The first-year interest expense is \(2,719,776.82\).

Step 1: Journalizing the Sale of Bonds

To record the sale of the bonds, we need to capture the cash received and the discount on bonds payable, as the bonds were sold at a discount. The journal entry is:- Debit Cash for the amount received: \(20,868,138\)- Debit Discount on Bonds Payable for the difference between the face value and the cash received: \(25,000,000 - 20,868,138 = 4,131,862\)- Credit Bonds Payable for the face value of the bonds: \(25,000,000\)

Step 2: Calculating First Interest Expense

To calculate the first interest payment, we need to determine the interest using the carrying amount of the bonds. The effective interest rate is 13%, compounded semiannually, so the rate used will be \(0.13 / 2 = 0.065\). The carrying amount at issuance is \(20,868,138\), so the interest expense is:\[ Interest Expense = 20,868,138 \times 0.065 = 1,356,428.97 \]

Step 3: First Semiannual Interest Journal Entry

For the first interest payment:- Credit Cash for the face amount of the bond's interest payment: \(25,000,000 \times 0.05 = 1,250,000\)- Debit Interest Expense for \(1,356,428.97\) as calculated in Step 2.- Debit Discount on Bonds Payable for the difference (amortization of the discount): \[ Amortization = 1,356,428.97 - 1,250,000 = 106,428.97 \]

Step 4: Calculating Second Interest Expense

The carrying amount after the first payment is the previous carrying amount plus the amortized discount:\[ Carrying Amount = 20,868,138 + 106,428.97 = 20,974,566.97 \]The interest expense for the second period, using the same effective rate:\[ Interest Expense = 20,974,566.97 \times 0.065 = 1,363,347.85 \]

Step 5: Second Semiannual Interest Journal Entry

For the second interest payment:- Credit Cash for the face amount interest: \(1,250,000\)- Debit Interest Expense for \(1,363,347.85\) as calculated in Step 4.- Debit Discount on Bonds Payable for the difference: \[ Amortization = 1,363,347.85 - 1,250,000 = 113,347.85 \]

Step 6: Total Bond Interest Expense for the First Year

The total bond interest expense for the first year is the sum of the interest expenses for the two periods:\[ Total Interest Expense = 1,356,428.97 + 1,363,347.85 = 2,719,776.82 \]

Key Concepts

Journal Entries for Bonds

When a company issues bonds, it's essential to properly record the transaction in the accounting records. A journal entry for the sale of bonds involves a few key components:

• Debit Cash: This represents the actual cash received from the issuance of the bonds. In this exercise, Simon Company received \( 20,868,138 \) from the sale.
• Debit Discount on Bonds Payable: A discount occurs when bonds are sold for less than their face value. It represents an additional interest expense over the life of the bonds. The discount here is calculated as \( 25,000,000 - 20,868,138 = 4,131,862 \).
• Credit Bonds Payable: This reflects the total obligation or the face value of the bonds which is \( 25,000,000 \).

This entry accurately reflects the cash inflow and future financial obligations, ensuring that the company's books are balanced.

Interest Expense Calculation

Interest expense is a crucial element in understanding the cost of borrowing. It is calculated based on the carrying amount of the bonds and the effective interest rate.
Simon Company’s bonds were issued at a 13% effective rate, requiring adjustments semiannually. Calculate the first interest expense as follows:

• Carrying Amount: Starts at \( 20,868,138 \) at issuance.
• Interest Calculation: The effective semiannual rate is \( 0.065 \) (or half of 13%), so the interest expense is \( 20,868,138 \times 0.065 = 1,356,428.97 \).

The second period's interest will be slightly different due to the previously amortized discount:

• Carrying Amount: Now \( 20,974,566.97 \) after the first payment's discount addition.
• Interest Expense: Calculated as \( 20,974,566.97 \times 0.065 = 1,363,347.85 \).

It's clear that the interest expense slightly increases as the carrying amount increases due to discount amortization.

Amortization of Bond Discount

Amortization of bond discount is the method of spreading the discount over the life of the bond, which adjusts the carrying value. This ensures that the interest expense over each period truly reflects the effective interest rate:

• First Period Amortization: The difference between interest expense and actual cash paid is \( 1,356,428.97 - 1,250,000 = 106,428.97 \).
• Second Period Amortization: As the carrying amount increases, this becomes \( 1,363,347.85 - 1,250,000 = 113,347.85 \).

Each period, the discount on bonds payable is debited by these amounts, reflecting the increased carrying value and ensuring the effective interest matches the payment structure. Understanding amortization helps in analyzing how debt costs affect financial statements long-term.