Problem 8 - Accounting

Question

Polders Corp., a wholesaler of office equipment, issued $16,000,000 of 20-year, 11% callable bonds on April 1, 2010, with interest payable on April 1 and October 1. The fiscal year of the company is the calendar year. Journalize the entries to record the following selected transactions: 2010 Apr. 1. Issued the bonds for cash at their face amount. Oct. 1. Paid the interest on the bonds. 2014 Oct. 1. Called the bond issue at 102, the rate provided in the bond indenture. (Omit entry for payment of interest.)

Step-by-Step Solution

Answer

Issue bonds, pay interest, call bonds at 102, record journal entries.

Step 1: Issuing the Bonds

On April 1, 2010, Polders Corp. issued bonds worth \(16,000,000 at their face value. To record this transaction, debit the cash account because the company receives cash, and credit the bonds payable account because it increases the company's liabilities. Journal Entry:\[\begin{align*}\text{Date} & : \text{April 1, 2010} \\text{Account} & \quad \text{Debit (\\))} \quad \text{Credit (\$)} \\text{Cash} & \quad \text{16,000,000} \\text{Bonds Payable} & \quad \quad \quad \quad \text{16,000,000} \\end{align*}\]

Step 2: Recording Interest Payment

On October 1, 2010, Polders Corp. paid interest on the bonds. The annual interest rate is 11%, and since the interest is paid semi-annually, calculate half of the annual interest. The interest for six months is calculated as follows:\[\text{Interest} = 16,000,000 \times 0.11 \div 2 = 880,000\]Debit the interest expense account to record the expense and credit the cash account to show the cash outflow. Journal Entry:\[\begin{align*}\text{Date} & : \text{October 1, 2010} \\text{Account} & \quad \text{Debit (\\()} \quad \text{Credit (\\))} \\text{Interest Expense} & \quad \text{880,000} \\text{Cash} & \quad \quad \quad \quad \text{880,000} \\end{align*}\]

Step 3: Calling the Bonds

On October 1, 2014, Polders Corp. called the bonds at 102, which means they paid 102% of the face value to redeem the bonds early. The redemption price is calculated as follows:\[\text{Redemption Price} = 16,000,000 \times 1.02 = 16,320,000\]Debit the bonds payable for the face amount of the bonds and a loss on the bond call for the difference between the redemption price and the bonds' book value. Credit cash to reflect the payout. Loss = Redemption Price - Book Value Remaining = 16,320,000 - 16,000,000 = 320,000.Journal Entry:\[\begin{align*}\text{Date} & : \text{October 1, 2014} \\text{Account} & \quad \text{Debit (\\()} \quad \text{Credit (\\))} \\text{Bonds Payable} & \quad \text{16,000,000} \\text{Loss on Bond Call} & \quad \text{320,000} \\text{Cash} & \quad \quad \quad \quad \text{16,320,000} \\end{align*}\]

Key Concepts

Journal Entries

Journal entries are an essential part of accounting. They record all financial transactions within an organization, which is crucial for maintaining accurate financial records. Think of them as the diary of a business's financial life.
To create a journal entry, you must understand the impact of a transaction on the company's accounts. This involves identifying which accounts are affected and whether they are increasing or decreasing.
For example, when Polders Corp. issued bonds, cash, which is an asset, increased by $16,000,000, so we debit this amount to the cash account. Simultaneously, a liability account, 'Bonds Payable,' also increased, which we credit by the same $16,000,000 amount. This keeps the balance sheet in equilibrium.

• Debit and credit have specific rules. Assets and expenses increase with a debit and decrease with a credit.
• Liabilities, equity, and revenue increase with a credit and decrease with a debit.

Understanding journal entries helps you see the direct effect of business activities on financial statements and the overall financial health of a company.

Callable Bonds

Callable bonds are a special type of bond that give the issuing company the right to redeem the bonds before they reach maturity. This means that the company can "call" the bonds back from bondholders at a predetermined price.
In our example, Polders Corp. issued callable bonds with a call provision at 102%. This means they could buy back their bonds by paying 102% of the bond's face value.

• Callable bonds are an advantage to issuers. They allow the company to refinance debt if interest rates drop, potentially saving on interest expenses.
• To investors, the call feature represents a risk because it limits the bond's potential total return. Bondholders might receive their principal back earlier than expected, usually when reinvestment opportunities are less favorable.

Understanding callable bonds is essential for evaluating certain investment risks and strategic financial decisions by issuing companies.

Interest Expense Calculation

Calculating interest expense on bonds is critical for accurate financial reporting. It reflects the cost a company incurs to borrow funds and is usually reported on the income statement.
In the case of Polders Corp., the bonds had an annual interest rate of 11%. However, because interest is paid semiannually, one needs to calculate the interest for just six months.
The formula for the semiannual interest expense is:\[\text{Semiannual Interest} = \text{Face Value} \times \text{Annual Interest Rate} \div 2\]
Here, the calculation works out as:\[16,000,000 \times 0.11 \div 2 = 880,000\]This $880,000 represents the interest expense recorded each time Polders Corp. pays interest, which happens twice a year, in April and October.

• Accurately calculating interest expenses is crucial because it affects net income and cash flow statements.
• Understanding how to calculate this ensures a company can plan for these cash outflows and manage its financial health effectively.