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Chapter 14: Question 3Q (page 752)

Distinguish between the following interest rates for bonds payable:

(a)Yield rate

(b) Nominal Rate

(c) Stated rate

(d) Market rate

(e) Effective rate

Short Answer

Expert verified

The yield rate is the rate actually earned by the bondholders. The nominal rate is the rate fixed by the one who issues the bonds, usually expressed as a percentage on par value. The stated rate is the specified rate listed on the bond. The market rate is the current rate prevailing in the market depending on various factors. The effective rateis the true rate on the bond, which takes into account the effects of compounding.

Step by step solution

01

Meaning of Bonds Payable

Bonds payable is a liability that arises when a company issues bonds to generate cash. The company is a borrower, thus creating a liability. Bonds can be issued at par, discount, and at a premium. The pricing depends on the difference between its coupon rate and its market yield.

02

(a) Yield rate

  • Yield rate is the rate of return the bond generates. It can say what percent was made from an investment.
  • A company can use this rate to compare various projects or investments to decide which is most profitable.
  • Current Yield = Annual cash/ Bond price
03

(b) Nominal rate

  • Nominal rate is the rate bond issuer promises to pay the bond purchaser.
  • The rate is fixed, expressed as a percentage on par value, and is applied to the lifetime of the bond.
  • It is the actual interest rate stated without considering the effect of compounding.
  • Nominal rate = Annual Interest payment/ Face value
04

(c) Stated rate

  • Stated rate is the actual rate listed on the bond
  • It is the actual amount of interest paid by the bond issuer, similar to the nominal rate.
  • Example, if an issuer pays $60 on a bond with the face value of $1000, then the stated interest rate is 6%.
  • Stated rate = Bond payment/ Face value
05

(d) Market rate

  • Market rate is the prevailing rate offered on cash deposits.
  • It is determined by the current rate compared to the rate specified in the bond.
  • It considers two things: The present value of the bond`s face value & Present value of the bond`s interest payments.
  • This rate is driven by many factors such as the size and duration of deposits, the flow of funds in & out of the country, etc.
  • Market rate = Bond`s face value * Bond`s price quote
06

(e) Effective rate

  • Effective rate is the rate that will discount both the bond`s future. interest payments and the bond`s maturity value to a present value that is equal to the bond`s current market value.
  • It is similar to market and yield rate, but it takes into account the effects of compounding.
  • The more frequent the compounding period, the higher the rate.
  • Effective rate = [ 1 + i/n ] n - 1

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Most popular questions from this chapter

Question: Why would a company wish to reduce its bond indebtedness before its bonds reach maturity? Indicate how this can be done and the correct accounting treatment for such a transaction.

The following article appeared in the Wall Street Journal.

Bond Markets

Giant Commonwealth Edison Issue Hits Resale Market With \(70 Million Left Over

New york—Commonwealth Edison Co.’s slow-selling new 91 /4% bonds were tossed onto the resale market at a reduced price with about \)70 million still available from the \(200 million offered Thursday, dealers said.

The Chicago utility’s bonds, rated double-A by Moody’s and double-A-minus by Standard & Poor’s, originally had been priced at 99.803, to yield 9.3% in 5 years. They were marked down yesterday the equivalent of about \)5.50 for each $1,000 face amount, to about 99.25, where their yield jumped to 9.45%.

Instructions

  1. How will the development above affect the accounting for Commonwealth Edison’s bond issue?
  2. Provide several possible explanations for the markdown and the slow sale of Commonwealth Edison’s bonds.

McCormick Corporation issued a 4-year, \(40,000, 5% note to Greenbush Company on January 1, 2017, and received a computer that normally sells for \)31,495. The note requires annual interest payments each December 31. The market rate of interest for a note of similar risk is 12%. Prepare McCormick’s journal entries for (a) the January 1 issuance and (b) the December 31 interest.

Question: Describe how a company would classify debt that includes covenants. What conditions must exist in order to depart from the normal rule?

Part I: The appropriate method of amortizing a premium or discount on issuance of bonds is the effective-interest method.

Instructions

  1. What is the effective-interest method of amortization and how is it different from and similar to the straight-line method of amortization?
  2. How is amortization computed using the effective-interest method, and why and how do amounts obtained using the effective-interest method differ from amounts computed under the straight-line method?

Part II: Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways:

  1. Amortized over remaining life of old debt.
  2. Amortized over the life of the new debt issue.
  3. Recognized in the period of extinguishment

Instructions

  1. Develop supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt.
  2. Which of the methods above is generally accepted and how should the appropriate amount of gain or loss be shown in a company’s financial statements?
See all solutions

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