Question

Lance Brothers Enterprises acquired $720,000 of 3% bonds, dated July 1, on July 1, 2016, as a long-term investment. Management has the positive intent and ability to hold the bonds until maturity. The market interest rate (yield) was 4% for bonds of similar risk and maturity. Lance Brothers paid $600,000 for the investment in bonds and will receive interest semiannually on June 30 and December 31. Prepare the journal entries (a) to record Lance Brothers’ investment in the bonds on July 1, 2016, and (b) to record interest on December 31, 2016, at the effective (market) rate.

Answer 1

(a)

July 1, 2016

Dr. Investment in Bonds $720,000

Cr. Discount on Bonds $120,000

Cr. Cash $600,000

(b)

December 31, 2016

Dr. Cash $10,800

Dr. Discount on Bonds $1200

Cr. Interest Income $12,000

Step-by-step explanation:

Investment in the bonds with intention to hold the bond until maturity is classified as the fixed investment and reported in the fixed assets section of the balance sheet.

When the bond is purchased below the face value of the bond, it is issued on discount by the issuer. This discount will be recorded and amortized over the bond life to maturity. Amortized discount will be added to the interest received amount to adjust this value in interest income.

Interest Received = Face value x Coupon rate x 6/12 = $720,000 x 3% x 6/12 = $10,800 semiannually

Interest income = Carrying Balance of Bond x market Rate x 6/12 = $600,000 x 4% x 6/12 = $12,000 semiannually

Now we will calculate the difference between the interest received and interest income to determine the value of discount amortized.

Amortized Discount = $12,000 - $10,800 = $1,200

Answer 2

A) July 1, 2016, 3% bonds are acquired as long term investment.

Dr Investment in 3% bonds 720,000

Cr Cash 600,000

Cr Discount on investment in 3% bonds 120,000

B) December 31, 2016, interest earned from investment in 3% bonds.

Dr Cash 10,800

Dr Discount on investment in 3% bonds 1,200

Cr Interest revenue 12,000

Explanation:

the bonds' face value is $720,000 but since the company paid only $600,000 for them, it means that it bought them at a discount price. Therefore, the discount, $720,000 - $600,000 = $120,000, must be recorded, and later amortized.

To calculate the amount of interest revenue that will be amortized as discount on investment:

(bonds' market price x market interest rate x 1/2) - (bonds' face value x coupon rate x 1/2) = ($600,000 x 4% x 1/2) - ($720,000 x 3% x 1/2) = $12,000 - $10,800 = $1,200