Question

Wilbury Corporation issued $1 million of 13.5% bonds for $985,071.68. The bonds are dated and issued October 1, 2016, are due September 30, 2020, and pay interest semiannually on March 31 and September 30. Assume an effective yield rate of 14%

Required:

1. Prepare a bond interest expense and discount amortization schedule using the straight-line method.

2. Prepare a bond interest expense and discount amortization schedule using the effective interest method.

3. Prepare adjusting entries for the end of the fiscal year December 31, 2016, using the: a. straight-line method of amortization b. effective interest method of amortization

4. If income before interest and income taxes of 30% in 2017 is $500,000, compute net income under each alternative.

5. Assume the company retired the bonds on June 30, 2017, at 98 plus accrued interest. Prepare the journal entries to record the bond retirement using the: a. straight-line method of amortization b. effective interest method of amortization

6. Compute the company’s times interest earned (pretax operating income divided by interest expense) for 2017 under each alternative.

Answer 1

1)

In straight line method, any discount allowed for issuance of bonds will be amortized in equal installments in every interest period.

Date	Payment of interest (a) ($)	Amortized discount (b) $	Interest expense (c) $	Book value(d) $
	($1000000x13.5%)/2	($14,928.32) / 8	(a+b)	(b+d)
01/10/2016				985071.68
31/03/2017	67500	1866.04	69366.04	986937.75
30/09/2017	67500	1866.04	69366.04	988803.76
31/03/2018	67500	1866.04	69366.04	990669.80
30/09/2018	67500	1866.04	69366.04	992535.84
31/03/2019	67500	1866.04	69366.04	994401.88
30/09/2019	67500	1866.04	69366.04	996267.92
31/03/2020	67500	1866.04	69366.04	998133.96
30/09/2020	67500	1866.04	69366.04	1000000

2)

Bond interest exp and amortizaton schedule under effective interest method

Date	Effective interest (a) $	Actual Interest (b) $	Discount amortized (c) $	Book Value (d) $
	(d x 14%)/2	($1000000x13.5%)/2	(a-b)	(a+d)
01/10/2016				985071.68
31/03/2017	68955.02	67500	1455.02	986526.70
30/09/2017	69056.87	67500	1556.87	988083.57
31/03/2018	69165.85	67500	1665.85	989749.42
30/09/2018	69282.46	67500	1782.46	991531.88
31/03/2019	69407.23	67500	1907.23	993439.11
30/09/2019	69540.74	67500	2040.74	995479.84
31/03/2020	69683.59	67500	2183.59	997663.43
30/09/2020	69836.44	67500	2336.57	1000000.00

3)

a)

Adjusting entries for the end of the fiscal year December 31,2016 under straight line method of Amortization

Date	Particulars	Debit ($)	Credit($)
December 31	Interest Expense Dr ($33750+933.02) To Discount on bonds ($1866.04x3)/6 To Interest payable ($67500x3)/6 (Being interst payable)	34683.02	933.02 33750

b)

Journal entries under Effective Interest method of amortization

Date	Particulars	Debit ($)	Credit ($)
Dec 31	Interest Expense dr To Discount on bonds To Interst Payable (Being Interest Payable)	34477.51	727.51 33750

4)

Interest under Straight line method for the period 01/01/2017 to 31/12/2017

Interest = $69366.04 x 2 = $138732.08

Interst Under Effective interest method for the period 01/01/2017 to 31/12/2017 :

Interest from 01/01/2017 to 31/3/2017 ($68955.02-$34683.02) = $34272

Interest from 01/04/2017 to 30/09/2017 is $69056.87

Interest from 1/10/2017 to 31/12/2017 ($988083.57x14%)x3/12 = $34582.92

Interes for the period is t01/01/2017 to 31/12/2017 =$34272 +$69056.87+$34582.92

=$137911.79

now Net income for 2017 under each alternative

Particulars	Straight line method ($)	Effective Interest method ($)
Operating income	500000	500000
(-) Interest for 2017	138732	137912
Net income for 2017	361268	362088
(-) Tax @30%	108380	108626
Income after tax	252888	253462

5)

a)

If redemption is betweenInterst payment dates , we have to pass journal entries for interest and discount from date of previous interest payment to the date of redemption.

Journal entries for march 31,2017 to June 30,2017

Date	Particulars	Debit ($)	Credit ($)
june 30	Interest Expense dr	34683.02
	To discount on bonds		933.02
	To interest Payable ( being Interest Payable)		33750

Calculation of carrying value of bonds :

Book value of bonds on March 31 2017 is $986937.72

discount amortized from march to june is $933.02

Carrying value of bonds on 30/06/2017 = $986937.72+$933.02= $987870.74

Gain / loss from Redemption = Carrying Value - call price without interest

= $987870.74 - $980000 = $7870.74

Journal entries for redemption of bonds

Date	Particulars	Debit ($)	Credit ($)
june 30 2017	Bonds payable dr	100000
	Interest payable dr	33750
	To gain through redemption of bonds		7870.74
	To Discounts on bonds payable		12129.26
	To cash/bank ($980000+$33750) (being bond redeemed)		1013750

b) Effective Interest method of amortization

Date	Particulars	Debit $	Credit $
june 30 2017	Interest dr ($986526.70x14%x3)/12	34528.43
	To discount on bonds payable ($1866.04x3/6)		778.43
	To interest payable $67500x3/6 (Being Interest payable)		33750

Carrying value of bonds = book value of bonds on 31st march 2017 + discount amortized for march 31 to june 30 2017

= $986526.70+$778.43 = $987305.13

Gain/loss from redemption of bonds = $987305.13 - $980000 = $7305.13

Journal Entries

Date	Particulars	Debit $	Credit $
June 30 2017	Bond payable dr	1000000
	Interest Payable dr	33750
	To profit from redemption		7305.13
	To discount on bonds payable		12694.87
	To cash/bank (being bonds redeemed)		1013750

6)

Time Interest Earned ratio = pretax operating income/interest expense

straight line method : $500000/$138732.08 = $3.60

Effective interest method : $500000/$137911.79=$3.63