Problem 7 - Accounting

Question

Daan Corporation wholesales repair products to equipment manufacturers. On March 1, 2010, Daan Corporation issued \(24,000,000 of five-year, 12% bonds at an effective interest rate of 10%, receiving cash of \)25,853,146. Interest is payable semiannually on March 1 and September 1. Journalize the entries to record the following: a. Sale of bonds on March 1, 2010. b. First interest payment on September 1, 2010, and amortization of bond premium for six months, using the straight-line method. (Round to the nearest dollar.)

Step-by-Step Solution

Answer

Journal entries: March 1 - Debit Cash 25,853,146; Credit Bonds Payable 24,000,000; Credit Premium on Bonds Payable 1,853,146. September 1 - Debit Interest Expense 1,254,685; Debit Premium on Bonds Payable 185,315; Credit Cash 1,440,000.

Step 1: Determine the Bond Premium

The bond premium is the difference between the cash received and the face value of the bonds issued. Given the cash received is \(25,853,146\) and the face value of the bonds is \(24,000,000\), the bond premium is \(25,853,146 - 24,000,000 = 1,853,146\).

Step 2: Journal Entry for Sale of Bonds

On March 1, 2010, when the bonds are issued, we need to make a journal entry to record the sale. Debit 'Cash' for \(25,853,146\), credit 'Bonds Payable' for \(24,000,000\), and credit 'Premium on Bonds Payable' for \(1,853,146\).

Step 3: Calculate Semiannual Interest Payment

The semiannual interest expense based on the bond's face value is calculated as \(24,000,000 \times 0.12 \times \frac{1}{2} = 1,440,000\).

Step 4: Calculate Semiannual Amortization of Bond Premium

The total bond premium of \(1,853,146\) is amortized over the bond's life, which is five years (or 10 semiannual periods). The straight-line amortization per period is \(\frac{1,853,146}{10} = 185,315\).

Step 5: Journal Entry for Interest Payment and Premium Amortization

On September 1, 2010, make a journal entry to record the semiannual interest payment. Debit 'Interest Expense' for \(1,440,000 - 185,315 = 1,254,685\), debit 'Premium on Bonds Payable' for \(185,315\), and credit 'Cash' for \(1,440,000\).

Key Concepts

Interest Payment Calculation

Interest payments are an integral part of managing bonds. For Daan Corporation's bonds, the face value is used to determine these payments. The bonds have a face value of \(24,000,000\) and an interest rate of 12\%, which applies annually. However, since payments are semiannual, the calculation adjusts accordingly.

To calculate the semiannual interest payment, we divide the annual rate by two and multiply it by the face value:

• Annual interest rate: 12\%
• Semiannual interest rate: 12\% / 2 = 6\%
• Semiannual interest payment: \(24,000,000 \times 0.06 = 1,440,000\)

This calculation helps ensure Daan Corporation meets its obligations to bondholders every six months, delivering prompt payments in line with the bond's terms.

Bond Premium Amortization

When bonds are sold for more than their face value, the extra amount is known as a bond premium. In this case, Daan Corporation received \(25,853,146\) for bonds with a face value of \(24,000,000\). The premium, therefore, is \(1,853,146\).

The premium must be amortized over the life of the bond, which in this scenario is five years or ten semiannual periods. Amortizing the premium lightens the interest expense each period since the premium acts as a deferred credit to interest.

Each semiannual period, \(185,315\) of the premium is recognized, calculated like this:

• Total premium: \(1,853,146\)
• Semiannual periods: 10
• Semiannual amortization: \(1,853,146 \div 10 = 185,315\)

Recognizing this amount in each period gradually adjusts the bond's carrying value, aligning it with its face value by maturity.

Straight-Line Method

The straight-line method is a straightforward technique used to amortize the bond premium. The aim is to spread the premium evenly across the bond's life.

In Daan Corporation's case, the bond premium of \(1,853,146\) is spread across ten periods (five years with semiannual payments), giving a constant amortization amount for each period.

• Even allocation simplifies the accounting process.
• It provides a stable expense pattern for financial statements.

This method contrasts with other techniques like the effective interest method, which recalculates interest each period. However, for many businesses, especially those looking for simplicity, the straight-line method proves efficient and easy to apply. This method results in a clear and consistent adjustment to the bond premium over time.