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On June 30, Year 1, Block Co. acquired $100,000 face amount, 3-year, 9% bonds of Blue Co. for...

Question:

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?

A. $100,000

B. $99,101

C. $98,274

D. $97,880

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.

Date Nominal
Interest (9%)
Effective
Interest (10%)
Amortization Carrying value
of the bonds
June 30 97,880.00
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%.

Year 1

  • 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

Year 2

  • 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

Learn more about this topic:

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How to Calculate Interest Expense: Formula & Example

from Financial Accounting: Help and Review

Chapter 5 / Lesson 18
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