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Chapter 14: Q8Q (page 753)

Question: Zopf Company sells its bonds at a premium and applies the effective-interest method in amortizing the premium. Will the annual interest expense increase or decrease over the life of the bonds? Explain.

Short Answer

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Answer

The annual interest expense will decrease each period all over the duration of the bonds. When bonds are sold at a premium, their carrying value falls to par value throughout their life; thus, the interest expense also falls.

Step by step solution

01

Meaning of annual interest expense

Interest expense is considered a non-operating expense showed on the income statement.

02

Decrease in the annual interest expense over the life of bonds

In the effective-interest method, the interest expense for each period is similar to the yield interest rate or effective interest rate times the carrying value of the bonds at the starting of each interest period. Carrying value descends to maturity value throughout their life, when the bonds are sold at a premium, consequently, the interest expense also declines.

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Most popular questions from this chapter

Donald Lennon is the president, founder, and majority owner of Wichita Medical Corporation, an emerging medical technology products company. Wichita is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production. Donald, as owner of 51% of the outstanding stock, manages the company’s operations. He places heavy emphasis on research and development and long-term growth. The other principal stockholder is Nina Friendly who, as a nonemployee investor, owns 40% of the stock. Nina would like to deemphasize the R & D functions and emphasize the marketing function to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Wichita’s stock.

All of Donald’s personal capital and borrowing power is tied up in his 51% stock ownership. He knows that any offering of additional shares of stock will dilute his controlling interest because he won’t be able to participate in such an issuance. But, Nina has money and would likely buy enough shares to gain control of Wichita. She then would dictate the company’s future direction, even if it meant replacing Donald as president and CEO.

The company already has considerable debt. Raising additional debt will be costly, will adversely affect Wichita’s credit rating, and will increase the company’s reported losses due to the growth in interest expense. Nina and the other minority stockholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of “his” company, Donald is doing everything to avoid a stock issuance and is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.

Instructions

(a) Who are the stakeholders in this situation?

(b) What are the ethical issues in this case?

(c) What would you do if you were Donald?

Using the same information as in E14-22 and E14-24, answer the following questions related to American Bank (creditor).

Instructions

  1. Compute the loss American Bank will suffer under this new term modification. Prepare the journal entry to record the loss on American’s books.
  2. Prepare the interest receipt schedule for American Bank after the debt restructuring.
  3. Prepare the interest receipt entry for American Bank on December 31, 2018, 2019, and 2020.
  4. What entry should American Bank make on January 1, 2021?

Vargo Corp. owes \(270,000 to First Trust. The debt is a 10-year, 12% note due December 31, 2017. Because Vargo Corp. is in financial trouble, First Trust agrees to extend the maturity date to December 31, 2019, reduce the principal to \)220,000, and reduce the interest rate to 5%, payable annually on December 31.

Instructions

  1. Prepare the journal entries on Vargo’s books on December 31, 2017, 2018, 2019.
  2. Prepare the journal entries on First Trust’s books on December 31, 2017, 2018, 2019.

On January 1, 2017, JWS Corporation issued \(600,000 of 7% bonds, due in 10 years. The bonds were issued for \)559,224, and pay interest each July 1 and January 1. JWS uses the effective-interest method. Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry. Assume an effective-interest rate of 8%

Assume the same information as in E14-4, except that Celine Dion Company uses the effective-interest method of amortization for bond premium or discount. Assume an effective yield of 9.7705%

Instructions

Prepare the journal entries to record the following. (Round to the nearest dollar.)

(a) The issuance of the bonds.

(b) The payment of interest and related amortization on July 1, 2017.

(c) The accrual of interest and the related amortization on December 31, 2017.
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