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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

On January 1, Patterson Inc. issued \(5,000,000, 9% bonds for \)4,695,000. The market rate of interest for these bonds is 10%. Interest is payable annually on December 31. Patterson uses the effective-interest method of amortizing bond discount. At the end of the first year, Patterson should report bonds payable of:

(a) \(4,725,500. (c) \)258,050.

(b) \(4,714,500. (d) \)4,745,000

Differentiate between a fixed-rate mortgage and a variable-rate mortgage.

On January 1, 2017, Ellen Carter Company makes the two following acquisitions.

  1. Purchases land having a fair value of \(200,000 by issuing a 5-year, zero-interest-bearing promissory note in the face amount of \)337,012.
  2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of $250,000 (interest payable annually).

The company has to pay 11% interest for funds from its bank

Instructions

(Round answers to the nearest cent.)

  1. Record the two journal entries that should be recorded by Ellen Carter Company for the two purchases on January 1, 2017.
  2. Record the interest at the end of the first year on both notes using the effective-interest method.

Gottlieb Co. owes \(199,800 to Ceballos Inc. The debt is a 10-year, 11% note. Because Gottlieb Co. is in financial trouble, Ceballos Inc. agrees to accept some land and cancel the entire debt. The property has a book value of \)90,000 and a fair value of $140,000.

Instructions

  1. Prepare the journal entry on Gottlieb’s books for debt restructure.
  2. Prepare the journal entry on Ceballos’s books for debt restructure

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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