Question

On February 1, 2018, Wolf Inc. issued 10% bonds dated February 1, 2018, with a face amount of $270,000. The bonds sold for $323,440 and mature in 20 years. The effective interest rate for these bonds was 8%. Interest is paid semiannually on July 31 and January 31. Wolf's fiscal year is the calendar year. Wolf uses the effective interest method of amortization.

Required:
1. Prepare the journal entry to record the bond issuance on February 1, 2018.
2. Prepare the entry to record interest on July 31, 2018.
3. Prepare the necessary journal entry on December 31, 2018.
4. Prepare the necessary journal entry on January 31, 2019.

Answer 1

Calculating the present value of a bond involves discounting its future payments, including interest and principal, to their current worth using the market interest rate. When a bond's interest rate is lower than the market rate, its price will be less than its face value. Examples with simple two-year bonds and the considerations of changes in market rates illustrate how bond pricing works.

Step-by-step explanation:

Calculating the Present Value of Bonds

When a bond's interest rate is lower than the market interest rate, its price will be less than the face value. To calculate the bond's price, you look at the future payments and discount them to their present value. If the interest rate of a bond is 8% and the market rate is also 8%, the bond would be worth its face value. However, with a market rate higher than the bond's rate, such as 11%, the present value of those future payments will be less, resulting in a bond price lower than the face value.

Using a simple bond as an example: a two-year bond with a face value of $3,000 and an interest rate of 8% will pay $240 in interest annually. To find the present value of this bond when the discount rate matches the bond's interest rate at 8%, each payment and the principal are discounted back to their present value. If the discount rate is 11%, the present value of each payment is less, indicating the bond's price will decrease.

For the local water company's bond with a face value of $10,000 and an interest rate of 6%, if market rates move to 9% a year before maturity, the price of the bond will be less than the face value. The expected final payment of $10,600 (principal plus interest) will be discounted using the new market rate of 9% to find its present value.

If the expected payments from a bond are $1,080 in the last year, including the final interest payment and the principal repayment, and market interest rates are at 12%, you would not pay more than the amount that could earn you $1,080 in a year with the current market rate. In this case, $964 invested at 12% returns $1,080, so the bond's price should not exceed $964.

Answer 2

Required 1

Cash $323,440 (debit)

Bonds Payable $323,440 (credit)

Required 2

Interest Expense $12,938 (debit)

Bond Payable $12,938 (credit)

Required 3

J1

Interest Expense $12,961 (debit)

Bond Payable $12,961 (credit)

Interest accrued on Bond

J2

Bond Payable $12,938 (debit)

Cash $12,938 (credit)

Interest Cash outflow

Required 4

J1

Interest Expense $12,961 (debit)

Bond Payable $12,961 (credit)

Interest accrued on Bond

J2

Bond Payable $12,938 (debit)

Cash $12,938 (credit)

Interest Cash outflow

Step-by-step explanation:

First, determine the coupon payments as follows :

FV = ($270,000)

PV = $323,440

N = 20

P/yr = 1

I = 8%

PMT = ?

Using a Financial Calculator, the annual coupon payments will be $27,042 ($12,938 semi-annually).

July 31,2018

Effective Interest Calculation

Effective Interest = $323,440 × 8% × 1/2

= $12,938