Question

On January 1, 2023, Novotna Company purchased $400,000 worth of 8% bonds of Aguirre Co. for $369,114. The bonds were purchased to yield 10% interest. Interest is payable semi-annually, on July 1 and January 1. The bonds mature on January 1, 2028. Novotna uses the effective interest method to amortize the discount or premium. On January 1, 2025, to meet its liquidity needs, Novotna sold the bonds for $370,726, after receiving interest.

Instructions

Prepare the journal entry to record the purchase of bonds on January 1. Assume that the bonds are classified as FV-OCI.
Prepare the amortization schedule for the bonds. Round all amounts to the nearest dollar.
Prepare the journal entries to record the semi-annual interest on July 1, 2023, and December 31, 2023.
Assuming the fair value of the Aguirre bonds is $372,726 on December 31, 2024, prepare the necessary adjusting entry. (Assume that the fair value adjustment balance on January 1, 2024, is a debit of $3,375.)

Answer 1

Students are asked to prepare journal entries and an amortization schedule for a bond purchase using the effective interest method and to make fair value adjustments. The question involves calculations based on bond principal, coupon rates, yield rates, and fair value estimates.

Step-by-step explanation:

The direct answer to the student's question involves preparing journal entries for a bond investment and adjusting for fair value using the effective interest method. The student is provided with the initial investment details, a need for an amortization schedule, and subsequent interest and fair value adjustments. As the scenario deals with interest rates, present value methods, and bond valuation, it requires a firm understanding of the accounting and finance concepts related to bond investments.

To answer this, one would have to calculate the interest payment based on the 8% coupon rate, which is $400,000 x 8% = $32,000 annually, or $16,000 semi-annually. For the first six months, interest revenue at the yield rate (10% annual or 5% semi-annual) on the book value of the bond ($369,114) is $369,114 x 5% = $18,456 (rounded to the nearest dollar). The first journal entry would be a debit to Investment in Bonds for $369,114, a credit to Cash for the same amount, and a semi-annual interest journal entry would debit Interest Receivable for $16,000, credit Interest Revenue for $18,456, and credit Discount on Bond Investment for $2,456 (which is the difference between interest revenue and receivable).

The amortization schedule would show the gradual increase in the bond's book value from $369,114 to $400,000 over the bond's life, adjusted each period by the amortization of the discount which is the difference between interest revenue calculated at the yield rate and interest received at the coupon rate.

Adjusting for fair value on December 31, 2024, requires a fair value adjustment based on the new valuation. The fair value adjustment would be a debit to Fair Value Adjustment and a credit to Unrealized Gain/Loss on Investments for the amount necessary to adjust the book value from its current value to $372,726.