Question

Fuzzy Monkey Technologies, Inc., purchased as a long-term investment $220 million of 8% bonds, dated January 1, on January 1, 2021. Management intends to have the investment available for sale when circumstances warrant. For bonds of similar risk and maturity the market yield was 10%. The price paid for the bonds was $201 million. Interest is received semiannually on June 30 and December 31. Due to changing market conditions, the fair value of the bonds at December 31, 2021, was $210 million.

Required:
1. to 3. Prepare the relevant journal entries on the respective dates (record the interest at the effective rate).
4-a. At what amount will Fuzzy Monkey report its investment in the December 31, 2021, balance sheet?
4-b. Prepare the entry necessary to achieve this reporting objective.
5. How would Fuzzy Monkey's 2021 statement of cash flows be affected by this investment? (If more than one approach is possible, indicate the one that is most likely.)

Answer 1

Fuzzy Monkey Technologies, Inc. records its bond investments at fair value, with interest calculated at the effective interest rate. The present value of a bond decreases when the market rate exceeds the coupon rate. The bond investment affects Fuzzy Monkey's statement of cash flows by reflecting interest as operating cash flows and changes in investments under investing cash flows.

Step-by-step explanation:

Fuzzy Monkey Technologies, Inc's investment in bonds requires accounting for the interest income and changes in fair value of the investment. When the market interest rate is higher than the bond's coupon rate, the bond is purchased at a discount. In this scenario, the company bought $220 million of 8% bonds at a price of $201 million. Interest is received semiannually, and the market yield at the purchase date was 10%. At year-end, the fair value of the bonds went up to $210 million.

For a simple two-year bond, the price can be calculated using the present value of future payments (interest and principal repayment) discounted at the market rate of interest. When the new discount rate (market rate) is greater than the coupon rate, the present value of the bond decreases. This is because future cash flows are discounted at a higher rate, reflecting a higher opportunity cost of money.

When considering the effect on Fuzzy Monkey's statement of cash flows for 2021, interest received from the bonds would be reported as operating cash flows. The purchase of the bonds, a long-term investment, would appear under investing cash flows. Lastly, the unrealized gain resulting from the increase in the fair value of the bonds would not affect the cash flows but would be part of other comprehensive income and reflected in the equity section of the balance sheet.

In the case of open market operations, when the Fed buys bonds from a bank like Acme Bank, the bank's reserves increase while its holdings of bonds decrease. These reserves can subsequently be used by the bank to create more loans, potentially increasing the money supply.

Answer 2

Answer and Explanation:

1 to 3.

Journal Entries - Fuzzy Monkey Technologies Inc.

Debit (In Million) Credit (In Million)

1. 1-Jan-21

Dr Investment in Bond Dr $220.00

Cr To Cash $201.00

CrTo Discount on bond investment $19.00

2.

30-Jun-21

Dr Cash ($220 *8% * 6/12) $8.80

Dr Discount on bond investment Dr $1.25

Cr To Interest revenue ($201*10%*6/12) $10.05

3.

31-Dec-21

Dr Cash ($220 *8% * 6/12) $8.80

Dr Discount on bond investment Dr $1.31

Cr To Interest revenue ($202.25*10%*6/12) $10.11

4a.

Fuzzy monkey report its investment on Dec 31, 2021 balance sheet at fair value which is $210 million

4b.

Journal Entries - Fuzzy Monkey Technologies Inc.

Debit (In Million) Credit (In Million)

1. 31-Dec-21

Dr Fair value adjustment ($210 - $201 - $1.25 - $1.31) $6.44

Cr To Unrealized holding gain or loss - OCI $6.44

5.

Statement of cash flows (Partial)

For 2021

Particulars Amount (In million)

Cash flow from operating activities:

Interest received $17.60 Inflow

Cash flow from investing activities:

Cash paid for purchase of investment $201.00

Outflow