Question

On January 1, 2021, Essence Communications issued $800,000 of its 10-year, 8% bonds for $700,302. The bonds were priced to yield 10%. Interest is payable semiannually on June 30 and December 31. Essence Communications records interest at the effective rate and elected the option to report these bonds at their fair value. On December 31, 2021, the market interest rate for bonds of similar risk and maturity was 9%. The bonds are not traded on an active exchange. The decrease in the market interest rate was due to a 1% decrease in general (risk-free) interest rates.

Required:
a. Using the information provided, estimate the fair value of the bonds at December 31, 2021.
b. Prepare the journal entry to record interest on June 30, 2021 (the first interest payment).
c. Prepare the journal entry to record interest on December 31, 2021 (the second interest payment).
d. Prepare the journal entry to adjust the bonds to their fair value for presentation in the December 31, 2021, balance sheet.

Answer 1

Answer:

A)

before decrease in rates: 706,483

   after rate decrease:            751,360

B)

interest expense 35,015.12

discount on BP 3,015.12

cash 32,000

--bonds first interest payment--

C)

interest expense 35,165.87

discount on BP       3,165.87

cash              32,000

--second interest payment--

D)

unrealized loss 44,877

  discount on bonds payable  44,877

--to adjust bonds valuation--

Explanation:

First, we solve for the present value of the bond to get the proceeds from the issuance.

$C \times \frac{1-(1+r)^{-time} }{rate} = PV$

C 32,000

time 20

rate 0.05

$32000 \times \frac{1-(1+0.05)^{-20} }{0.05} = PV$

PV $398,790.7310

$\frac{Maturity}{(1 + rate)^{time} } = PV$  

Maturity   800,000.00

time   20.00

rate  0.05

$\frac{800000}{(1 + 0.05)^{20} } = PV$  

PV   301,511.59

PV c $398,790.7310

PV m  $301,511.5863

Total $700,302.3173

Now, we do the table for the first year:

# / Principal/      paid /    interest /       Amort/End. P

1 700,302 32000 35015.12 3015.12 703,317

2 703,317 32000 35165.87 3165.87 706,483

Now, we have to redo the calculations for the bonds market value considering a decrease in the market rate to 9%

$C \times \frac{1-(1+r)^{-time} }{rate} = PV$

C 32,000

time 18

rate 0.045

$32000 \times \frac{1-(1+0.045)^{-18} }{0.045} = PV$

PV $389,119.7377

$\frac{Maturity}{(1 + rate)^{time} } = PV$  

Maturity   800,000.00

time   18.00

rate  0.045

$\frac{800000}{(1 + 0.045)^{18} } = PV$  

PV   362,240.30

PV c $389,119.7377

PV m  $362,240.2951

Total $751,360.0328

We adjust for: 751,360 - 706,483 = 44,877

This will be an unrealized loss as the liability increases but, will be realized on the redemption of the bonds or at the end of the bonds' life.