Problem 6 - Accounting

Question

On the first day of its fiscal year, Robbins Company issued \(50,000,000 of five-year, 8% bonds to finance its operations of producing and selling home improvement products. Interest is payable semiannually. The bonds were issued at an effective interest rate of 11%, resulting in Robbins Company receiving cash of \)44,346,760. a. Journalize the entries to record the following: 1\. Sale of the bonds. 2\. First semiannual interest payment. (Amortization of discount is to be recorded annually.) 3\. Second semiannual interest payment. 4 . Amortization of discount at the end of the first year, using the straight- line method. (Round to the nearest dollar.) b. Determine the amount of the bond interest expense for the first year.

Step-by-Step Solution

Answer

Total interest expense for the year is $4,565,324.

Step 1: Record Sale of Bonds

To record the issuance of bonds, we first note the amount of cash received and the difference between the face value and this cash as a discount. The journal entry is: Dr. Cash $44,346,760 Dr. Discount on Bonds Payable $5,653,240 (i.e., $50,000,000 - $44,346,760) Cr. Bonds Payable $50,000,000 This entry reflects the discount on bonds and the cash received from the bond issuance.

Step 2: First Semiannual Interest Payment

The first semiannual interest payment calculates the interest due based on the bond face value and stated interest rate for six months. Since this is recorded but the discount is not amortized yet, no entry is made for discount at this stage: Dr. Interest Expense $2,000,000 (i.e., $50,000,000 x 8% x 1/2) Cr. Cash $2,000,000 This entry records the cash payment of interest on the bond.

Step 3: Second Semiannual Interest Payment

The second semiannual interest payment is the same as the first. Like before, this ignores any amortization at this point: Dr. Interest Expense $2,000,000 (i.e., $50,000,000 x 8% x 1/2) Cr. Cash $2,000,000 This records the cash expense for the second interest payment.

Step 4: Amortization of Bond Discount

The discount on the bond must be amortized using the straight-line method. The total discount of $5,653,240 is divided evenly over the 10 periods (5 years x 2): Annual amortization = $5,653,240 / 10 = $565,324 The journal entry to record the annual amortization at the end of the year is: Dr. Interest Expense $565,324 Cr. Discount on Bonds Payable $565,324 This adjusts the Interest Expense to reflect the effective yield on the bond.

Step 5: Determine Total Interest Expense for the Year

The interest expense consists of actual cash interest payments plus the amortized discount amount: Total interest expense for the year = $2,000,000 + $2,000,000 + $565,324 = $4,565,324 This is the total interest expense, including both payments and amortization.

Key Concepts

Understanding Bond Issuance

When a company like Robbins Company issues bonds, it's essentially taking out a loan from the public. The company agrees to pay back a specified amount (the face value) at a future date, while also making periodic interest payments. In Robbins' case, bonds were issued at $50,000,000 with an annual interest rate of 8%. However, because the market demanded a higher return of 11%, they ended up receiving only $44,346,760.

• Bonds are a form of long-term debt used to raise money for company operations or expansions.
• The face value of a bond is the amount that will be repaid to the bondholder at maturity.
• The market interest rate influences the actual cash received. If it's higher than the bond's interest rate, the bond is sold at a discount.

Interest Expense Calculation

Calculating interest expense for bonds involves understanding the interest rate applied and the timing of payments. Robbins Company calculated their semiannual interest payment using the bond's face value. They had to calculate the interest for each six-month period using the stated 8% interest rate. The formula used is:\[\text{Interest Expense} = \text{Face Value} \times \text{Stated Interest Rate} \times \frac{6}{12}\]So for Robbins Company: \[\(50,000,000 \times 8\% \times \frac{1}{2} = \)2,000,000\]

• Interest is calculated on the bond's face value, not on the amount of cash received.
• Semiannual payments divide the annual interest into two equal parts.

Amortization of Bond Discount

The bond discount arises when bonds are sold for less than their face value, as was the case with Robbins Company. This discount reflects the additional interest cost to the company due to the higher market rate (11%) compared to the bond's stated rate (8%). Amortization of the discount means gradually reducing the bond discount on the financial statements. This adjustment helps in accurately reporting the company's interest expense over the bond's life.

• The total bond discount was $5,653,240.
• This amount needs to be spread over the bond's life (5 years in this case) or 10 semiannual periods.

Straight-Line Method for Amortization

The straight-line method simplifies the amortization of a bond discount by evenly spreading the discount amount over each period of the bond's term. For Robbins Company, this meant dividing their \(5,653,240 discount equally over the 10 periods.The formula for annual amortization is:\[\text{Annual Amortization} = \frac{\text{Total Discount}}{\text{Number of Periods}} = \frac{5,653,240}{10} = \)565,324\]This method implies that each year, Robbins would recognize an additional interest expense of $565,324 besides the semiannual interest payments.

• Straight-line amortization ensures equal expense recognition over the bond's life.
• It keeps financial reporting simple and consistent over each period.