Question

On 2 January 2016, ME Ltd (ME) issued $10,000,000 5-year bonds for $10,811,090. The stated coupon rate is 10% per annum, and the effective interest rate is 8% per annum. Interest is to be paid semi-annually on 30 June and 31 December. The company uses the effective interest rate method of amortizing bond discounts/premiums. As of its most recent financial year ended 31 December 2017, ME expects its net income before interest and tax to be constant over the next three financial years and does not foresee any further interest-bearing borrowings in the near future.

(i) Prepare an amortization schedule that covers the duration of the bond till 30 June 2018, using the effective interest rate method. Show all the necessary workings and round off your answers to the nearest dollar.

(ii) Prepare the necessary journal entries to record the cash interest payment on 31 December 2017.

(iii) “ME’s cash payment for interest decreases over the duration of the bond”. Comment on this statement.

(iv) Assume ME’s Times Interest Earned (TIE) ratio for the financial year ended 31 December 2017 is 5. What will its TIE ratio likely be for the next three years? Explain.

(v) Because of a substantial increase in the market rate of interest, ME purchased all the bonds on the open market at par on 30 June 2018. Prepare the journal entry to record the retirement of the bonds on 30 June 2018. Ignore the journal entry for the interest payment on 30 June 2018.

Answer 1

Answer-(i):

Answer-(ii):

Date	Account Name	Debit	Credit
12/31/2017	Interest expense	$    424,008.24
	Premium on bond payable	$      75,991.76
	Cash		$    500,000.00

Answer-(iii):

The interest expense over time decreases because premium is also amortized over the duration bond there by decreasing the carrying amount of bond on which interest is calculated.