Problem 9 - Accounting

Question

Vidovich Corp. produces and sells soccer equipment. To finance its operations, Vidovich Corp. issued $15,000,000 of 30-year, 14% callable bonds on January 1 , 2010, with interest payable on January 1 and July 1. The fiscal year of the company is the calendar year. Journalize the entries to record the following selected transactions: 2010 Jan. 1. Issued the bonds for cash at their face amount. July 1. Paid the interest on the bonds. 2016 July 1. Called the bond issue at 98, the rate provided in the bond indenture. (Omit entry for payment of interest.)

Step-by-Step Solution

Answer

Issue bonds at face, pay semi-annual interest, call bonds below face value and record gain.

Step 1: Issuance of Bonds

To record the issuance of the bonds on January 1, 2010, where Vidovich Corp. receives cash at the face amount of the bonds. The journal entry would be: - Debit 'Cash' for $15,000,000 - Credit 'Bonds Payable' for $15,000,000 This reflects the company receiving cash and creating a liability for the bonds payable.

Step 2: Payment of Interest on Bonds

To record the payment of interest on July 1, 2010. Since the interest is calculated semi-annually, the interest for six months needs to be recorded. The calculation is as follows:\[\text{Interest Payment} = \text{Face Value} \times \text{Interest Rate} \times \frac{1}{2} = 15,000,000 \times 0.14 \times \frac{1}{2} = 1,050,000\]The journal entry for this transaction is:- Debit 'Interest Expense' for \(1,050,000- Credit 'Cash' for \)1,050,000This records the expense incurred for interest and the reduction in cash due to payment.

Step 3: Bond Call at Premium

On July 1, 2016, the bonds are called at 98% of their face value. Calculate the call amount:\[\text{Call Amount} = \text{Face Value} \times \text{Call Rate} = 15,000,000 \times 0.98 = 14,700,000\]The journal entry for this transaction is:- Debit 'Bonds Payable' for \(15,000,000- Credit 'Cash' for \)14,700,000- Credit 'Gain on Redemption of Bonds' for $300,000This reflects the settlement of the bonds payable and the gain resulting from calling the bonds at a price lower than the face value.

Key Concepts

Journal Entries

Journal entries are the method businesses use to record their financial transactions. These are foundational to accounting as they ensure every financial transaction reflects correctly in the accounting books. When Vidovich Corp. issued bonds on January 1, 2010, they recorded this by making a journal entry. Specifically, they debited the 'Cash' account, which means they increased cash by $15,000,000, indicating that they received this amount from investors. Simultaneously, they credited 'Bonds Payable' by the same amount, which means they recognized a liability of $15,000,000, an obligation to repay the bond holders in the future.
When recording entries, it's essential always to identify the accounts affected and determine whether to debit or credit those accounts. A debit increases asset or expense accounts, while it decreases liability or equity accounts. Conversely, a credit increases liability or equity accounts and decreases asset or expense accounts.

Interest Payments

Interest payments represent the cost of borrowing money. For Vidovich Corp., this involved twice-annual payments to their bond investors as compensation for the loan. Interest is calculated using the formula:

• \[ \text{Interest Payment} = \text{Face Value} \times \text{Interest Rate} \times \frac{1}{2} \]
• For Vidovich, it's: \( 15,000,000 \times 0.14 \times \frac{1}{2} = 1,050,000 \)

In simple terms, the company paid \(1,050,000 every six months. The journal entry for this transaction involves debiting 'Interest Expense' by \)1,050,000—this shows a business cost or expenditure. Subesequently, 'Cash' is credited by the same amount, reflecting the cash outflow to bondholders. Interest payments are crucial financial obligations for companies with debt, and therefore accurately recording them is essential for maintaining proper financial statements.

Callable Bonds

Callable bonds provide the issuing company with the flexibility to repay their debt early. In Vidovich Corp.'s case, they took advantage of this feature on July 1, 2016, when they called their bonds at 98% of the face value. This means they decided to pay back the bondholders before the maturity date, usually because of favorable interest rate environments or to reduce debt. When calling bonds at 98%, Vidovich agreed to repay $14,700,000 for the $15,000,000 bonds. This aspect of callable bonds can also potentially lead to financial gains. Here, the company credited a 'Gain on Redemption of Bonds' by $300,000, representing the difference between the face value of the bonds and the call amount. The journal entry involves debiting 'Bonds Payable' by the original face value of $15,000,000, crediting 'Cash' with $14,700,000, and the gain is credited to complete the transaction. Callable bonds combine flexibility and potential savings for companies, albeit at the possible expense of bondholders anticipating longer interest payouts.