FAR-Bonds and Other Liabilities

On January 2, Vole Co. issued bonds with a face value of $480,000 at a discount to yield 10%. The

bonds pay interest semiannually. On June 30, Vole paid bond interest of $14,400. After Vole

recorded amortization of the bond discount of $3,600, the bonds had a carrying amount of

$363,600. What amount did Vole receive upon issuing the bonds?

• a. $360,000

• b. $367,200

• c. $476,400

• d. $480,000

Answer explanation

When bonds are issued, the bond price is adjusted to make its effective yield competitive with the current market rate for similar bonds. When the bond's stated rate differs from the market rate (ie, yield), it is priced at a discount or premium.

The carrying value (CV) of a bond equals its face value (FV) minus the discount or plus a premium. As the bond premium or discount is amortized, the CV of the bond changes.

Because the bonds in this scenario were issued at a discount, an amount less than FV ($480,000) was received. To calculate the amount Vole Co. received at issuance, determine the discount on June 30 from the carrying amount given, $363,600. Work backwards to calculate the discount at bond issuance.

Discount June 30

$480,000 FV − $363,600 CV = $116,400

Discount January 2

$116,400 + $3,600 amortization = $120,000

Bond Proceeds

$480,000 FV − $120,000 discount = $360,000

Check figure: $363,600 CV+$3,600 amortization=$360,000

A corporation recently issued $4 million of 10-year, 3% bonds at 101. There were 200,000 detachable stock warrants included as part of the sale. Each warrant allows the bondholder to purchase one share of no par common stock for $12 per share. On the date of issuance, the stock warrants had a fair value of $1 per warrant. By what amount did the corporation's long-term debt increase as a result of this issuance?

• a. $3,840,000

• b. $4,000,000

• c. $4,040,000

• d. $4,200,000

Answer explanation

To increase the demand and marketability of bonds, stock warrants may be issued with the bonds. When detachable stock warrants are issued with bonds, the sales proceeds must be allocated between the warrants and the bonds based on relative fair values on the date issued. Although bonds may sell for a price above face (par) value, allocating a portion of the proceeds to the warrants could result in the bonds being assigned a net value less than face value.

If only one fair market value is known that amount is allocated first and the remainder is assigned to the other security. The portion of the proceeds assigned to the warrants is recorded as paid-in capital (equity) and the remainder to the bond payable (liability). As result of the allocation, the company's long-term debt increases by $3,840,000.

4,040,000 - 200,000 = 3,840,000

If bonds are issued at a premium, total interest expense recorded over the life of a bond equals the cash interest payments

• a. Less the premium.

• b. Less par value.

• c. Plus the premium.

• d. Plus par value.

Answer explanation

When the bond's stated rate is greater than the market rate (10% stated rate ˃ 8% market rate), it is priced at a premium.

The effective interest method is used to amortize the premium, ensuring that the bond's interest expense correlates with its carrying value. The premium amortization doesn't change the required cash payments for interest; it is an adjustment to the amount of interest expense recorded each period. Therefore, over the life of the bond, the total interest expense recorded equals the total cash payments less the total premium.

On March 1, Year 1, Somar Co. issued 20-year bonds at a discount. By September 1, Year 5, the bonds were quoted at 106 when Somar exercised its right to retire the bonds at 105. How should Somar report the bond retirement on its Year 5 income statement?

• a. A gain in continuing operations.

• b. A loss in continuing operations.

• c. A gain in discontinued operations.

• d. A loss in discontinued operations.

Answer explanation

Somar Co. issued bonds at a discount (let say, 98% of face) in Year 1. The CV of the bonds is less than face value. In Year 5, Somar retired the bonds at 105 (105% of face). Since Somar paid more to retire the bonds than the CV, it will record a loss on bond retirement in its income from continuing operations.

Grant Co. issued $500,000 face value, five-year, 8% bonds on December 31, Year1.The bonds pay interest annually and were sold to yield 7%. Present value factors are as on the picture leftside.

What amount of long-term liability should Grant report on December 31, Year 1, for this sale?

• a. $500,000

• b. $512,777

• c. $520,501

• d. $531,981

Answer explanation

A bond is a borrowing agreement in which the issuer promises to repay to the purchaser a certain amount of money (ie, face/par value) after a certain period (ie, term) at a certain interest rate (ie, effective yield/market rate). Because bond payments occur over multiple years, the bond liability initially recorded will reflect the present value (PV) of the bond principal and interest payments. Specifically, calculating the proceeds from the issuance of bonds occurs by adding the following:

PV of bond principal

Face value × Market rate single sum PV factor

PV of interest payments

Face value × Stated rate × Market rate annuity PV factor

In this scenario, Grant Co. issued $500,000 face value, five-year, 8% (ie, stated rate) bonds on December 31, Year 1. The bonds pay interest annually and were sold to yield 7% (ie, market rate). The annual interest payment is $40,000 ($500,000 face value × 8% stated rate). Because payments occur at the end of each period, the ordinary annuity factors apply. The long-term liability balance of Grant's bonds is $520,501, calculated as follows:

PV of principal = Face value × PV of $1 @ 7%

$500,000 × 0.712986= $356,493

PV of interest payment = Interest × PV ordinary annuity @ 7%

$40,000 × 4.100197=$164,008

PV of the bonds (long-term liability balance)

$520,501

On January 1, Year 2, Oak Co. issued 400 of its 8%, $1,000 bonds at 97 plus accrued interest. The bonds are dated October 1, Year 1, and mature on October 1, Year 10. Interest is payable semiannually on April 1 and October 1. Accrued interest for the period October 1, Year 1, to January 1, Year 2, amounted to $8,000. On January 1, Year 2, what amount did Oak receive from the bond issuance?

• • a. $380,300

• b. $388,000

• c. $388,300

• d. $396,000

Answer explanation

A newly issued bond has a dated date when it begins to accrue interest. The issue date (when the bond is actually sold) can differ from the dated date. If the dated date precedes the issue date, the purchase amount includes accrued interest because the buyer will receive the entire interest payment on the next scheduled coupon date (April 1).

The issue price of a bond is expressed in terms of a percentage of the bond's par value. A price less than 100 indicates the bond was sold at a discount. Bond issue proceeds equal the bond's carrying value (Par value × Issue price) plus accrued interest from the dated date to the issue date.

In this scenario, Oak Co. issued bonds totaling $400,000 (400 bonds × $1,000 per bond) at a stated rate of 8% on January 1, Year 2. Since the bonds were issued after the October 1 dated date, 3 months (October, November, and December) of accrued interest must be included in the bond issue proceeds.

Carrying value: $400,000 par × 97% (priced at discount)= $388,000

Plus: accrued interest: $400,000 par × 8% stated rate × 3/12 months=8,000

Bond issue proceeds=$396,000

Ray Corp. issued 200 of its 8%, ten-year, $1,000 face value bonds for $240,000. Each bond contained 100 detachable stock warrants, each of which was for one share of Ray's common stock at $12 per share. Immediately after issuance, the market value of each warrant was $2, and the market value of the bonds without the warrants was $196,000. What amount of discount on the bonds should Ray record at issuance?

• a. $0

• b. $678

• c. $4,000

• d. $39,322

Answer explanation

In this scenario, Ray Corp. must first calculate the warrant FV before determining the relative FV percentages for bonds and warrants. Each bond contains 100 warrants with a market value of $2 each. Ray sold 200 bonds, resulting in 20,000 warrants (200 bonds × 100 warrants per bond). The warrant FV is $40,000 (20,000 warrants × $2 per warrant). The bond discount is $678, calculated as follows:

Determine relative fair value percentages:

FV of bonds (given) $196,000

FV of warrants $40,000

Total FV $236,000

% allocated to bonds

($196,000 / $236,000) = 83.05%

Allocate issue proceeds to bonds and warrants:

Proceeds $240,000

% allocated to bonds 83.05%

Carrying value (CV) of bonds $199,322

Discount on bonds payable is $678 ($200,000 face value − $199,322 CV)

Summer Corp. issued $1,000,000 face value bonds with detachable common stock warrants at 103. Immediately after the bonds were issued, the fair value of the warrants was $20,000, but the fair value of the bonds could not be determined. The issue price exceeded the sum of the warrants' fair value and the face value of the bonds. What amount of discount or premium on the bonds should Summer record at issuance?

• a. $20,000 discount

• b. $10,000 discount

• c. $10,000 premium

• d. $30,000 premium

Answer explanation

Summer Corp. has issued $1,000,000 face value bonds with detachable warrants. The FV of the bonds could not be determined. The warrant's FV of $20,000 is allocated to the warrants. The remainder of the bond issue proceeds is assigned to the bonds. If the amount assigned to the bonds is greater than face value, a premium on bonds payable is recorded.

The bonds are issued with a $10,000 premium ($1,010,000 assigned to bonds − $1,000,000 face value).

Bond issue proceeds $1,030,000　($1,000,000 face × 1.03)

Less: Warrant FV (known) (20,000)

　Proceeds allocated to warrants

Amount assigned to bonds $1,010,000)

　=> $10,000 premium

When debt is issued at a discount, interest expense over the term of debt equals the cash interest paid

• a. Minus discount.

• b. Minus discount minus par value.

• c. Plus discount.

• d. Plus discount plus par value.

Answer explanation

When a bond's stated rate is less than the market rate, it is priced at a discount to effectively yield the current rate. Interest expense over the term of the debt equals total cash payments for interest plus the total bond discount.

On July 31, Year 3, Dome Co. issued $1,000,000 of 10%, 15-year bonds at par and used a portion of the proceeds to call its 600 outstanding 11%, $1,000 face value bonds, due on July 31, Year 13, at 102 and retire them. On that date, unamortized bond premium related to the 11% bonds was $65,000. What amount should Dome report in its Year 3 income statement as gain or loss, before income taxes, from retirement of bonds?

• a. $53,000 gain.

• b. $0

• c. $65,000 loss.

• d. $77,000 loss.

Answer explanation

Gain or loss on bond redemption

Step 1: Determine bond carrying value

Bonds payable (face value)

+ Unamortized bond premium or

− Unamortized bond discount

− Unamortized bond issue costs

= Bond carrying value

Step 2: Compare carrying value to cash paid

Bond carrying value

− Cash paid to redeem bonds

= Gain or loss on bond redemption

Gain = Carrying value > Cash paid

Loss = Carrying value < Cash paid

A company may choose to retire its outstanding bonds when interest rates change or if it has excess cash reserves. Callable bonds are bonds issued that include an option for the issuer to repurchase (ie, retire) them from bondholders prior to maturity at a specified price.

When a bond is called prior to maturity, the difference between its carrying value (CV) and the amount paid is reported as a gain or loss on the bond issuer's income statement. CV for a bond issued at a premium equals the bond's face value (ie, face) plus unamortized bond premium and less any unamortized bond issue costs.

In this scenario, Dome Co. called 600 of its 11% bonds at 102 (ie, 102% of face) on July 31, Year 3. On that date, the called bond's face equaled $600,000 (ie, 600 bonds × $1,000 per bond), and the unamortized premium equaled $65,000 (Choice C). A gain of $53,000 is calculated by comparing the redemption date CV with the cash paid (Choice B).

Bond July 31 CV ($600,000 face + $65,000 premium) $665,000

Less: Cash paid ($600,000 face × 1.02) ($612,000)

Gain on bond retirement (ie, CV > cash paid) $53,000)