Question

Lamar Insurance purchased $100,000 of 7​% SVL bonds on January​ 1,2018​,at a price of 82 when the market rate of interest was 12​%. Lamar intends to hold the bonds until their maturity date of January​ 1,2023. The bonds pay interest semiannually on each January 1 and July 1. Lamar recorded the following journal entries on January​ 1,2018 and July​ 1,2018​:

Date Credit Journal Entry Accounts 1 Held-to-Maturity Investment in Bonds Cash Debit 82.000 Jan 82 000 Journal Entry Accounts Credit Debit 3 500 1 Cash Interest Revenue Credit Journal Entry Accounts 1 Held-10-Maturity Investment in Bonds Interest Receivable 1.800

Make the adjusting entries that Lamar Insurance would need to make on December​ 31,2018​, related to the investment in SVL bonds.

Answer 1

Bond face value = $100,000

Coupon Interest = 7%

Market rate =12% and Bond is purchased at 82 (at a discount)

Bond purchase price = 82% * $100,000 = $82,000

Bond discount = $100,000 - $82,000 = $18,000

This means that Lamar will get $100,000 face value from bond on Jan 1,2023 but had to pay only $82,000 for it today, i.e., Jan 1,2018. As per accrual concept, this additional benefit of $18,000 should be recognized /amortized over the life of the bond as additional interest income, such that by the end of the life of bond, bond value in books of accounts will increase from $82,000 to face value $100,000 with each interest recording.

Time period = Jan. 1, 2018 to Jan. 1, 2023 with semi-annual payments, so, 5 years * 2 = 10 time periods

Interest income in each year = Coupon interest * Bond face value

                                                      = 7% * $100,000 = $7,000

Semi-annual interest income = $7,000 / 2 = $3,500

So, journal entry to record interest income on Dec. 31, 2018 will be as follows:

Date	Particulars	Debit amount	Credit amount
Dec. 31,2018	Cash	3500
	Interest revenue		3500
	(Being bond interest received)

Further, bond discount of $18,000 is to be amortized over the life of the bond.

Using straight-line method, annual amortization will be $18,000 / 5 = $3,600

Semi-annual amortization = $3,600 / 2 = $1,800

So, journal entry to record amortization on Dec. 31, 2018 will be as follows:

Date	Particulars	Debit amount	Credit amount
Dec. 31,2018	Held-to-maturity investment in bonds	1800
	Interest receivable		1800
	(Being bond discount amortized for the period)

Further, interest receivable will be credited to interest income at the end of year as follows:

Dec. 31,2018	Interest receivable	3600
	Interest revenue		3600

Now, the value of bonds as on Dec. 31, 2018 will increase by the discount amortized semi-annually as additional interest income, i.e. $82,000 + $1,800 + $1,800 = $85,600

So, the balance sheet reports available-for-sale security of $85,600 as an asset.

Also, the balance sheet will include the unexpired/remaining bond discount of $18,000 – ($1,800*2) = $14,400

Since the bond discount for the period is to be recognized as interest revenue for the period, $1800 + $1800 = $3,600 to be added to interest income for the year in addition to $3,500 + $3,500 = $7,000 coupon interest received on the bonds.

So, the income statement reports interest revenue of $10,600 ($3,600+$7,000) for the year.