On June 30, Year 1, Block Co. acquired $100,000 face amount, 3-year, 9% bonds of Blue Co. for $102,380, including accrued interest. The bonds were issued to yield 10% and mature on December 31, Year 3. Interest is paid annually on December 31. What is the carrying amount of the bonds at December 31, Year 2, if the effective-interest method is used?
Effective Interest Method:
Effective interest method is a generally accepted accounting method for amortizing interest for bonds. Under this method, the amount of interest expense to be recognized for a particular period corresponds to the product of the bonds and the effective interest rate. When a bond is issued at a discount, the effective interest rate is higher than the nominal rate whereas if a bond is issued at a premium, the effective interest rate is lower than the nominal rate.
Answer and Explanation:
Answer: B. $99,101
Based on the given facts, the effective interest rate is higher than the nominal rate. Therefore, the bond was issued at a discount.
Step 1: Compute for the carrying value of the bonds at the time of acquisition.
Note that the amount paid is inclusive of accrued interest. Hence, we need to compute for the carrying value of the bonds at the time of acquisition.
- Carrying value of the bonds (June 30) = Acquisition cost - Accrued interest
- Carrying value of the bonds (June 30) = $102,380 - ($100,000 x 9% x 6/12)
- Carrying value of the bonds (June 30) = $102,380 - 4,500 = $97,880
Step 2: Prepare the amortization table.
|Amortization|| Carrying value
of the bonds
|Dec. 31, Year 1||4,500.00||4,894.00||394.00||98,274.00|
|Dec. 31, Year 2||9,000.00||9,827.40||827.40||99,101.40|
The nominal interest is calculated by multiplying $100,000 face amount and the nominal interest of 9%. While the effective interest rate is calculated by multiplying the carrying value of the bonds and the effective interest rate of 10%.
- Nominal interest (Annual) = $100,000 x 9% = $9,000
- Effective interest rate (June 30 - Dec. 31, Year 1) = $97,880 x 10% x 6/12 = $4,894
To determine the discount amortization to be added to the carrying value of the bonds, we'll compute the difference of the effective interest and the nominal interest.
- Amortization = $4,894 - $4,500 = $394
- Carrying value (Year 1) = $97,880 + $394 = $98,274
- Nominal interest = $100,000 x 9% = $9,000
- Effective interest rate = $98,274 x 10% = $9,827.40
- Amortization = $9,827.40 - $9,000 = $827.40
- Carrying value = $98,274 + $827.40 = $99,101.40
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from Financial Accounting: Help and ReviewChapter 5 / Lesson 18