Question 1: On January 1, 2013, Jennings, Inc. issued $400,000, 10-year, 10% bon

Question

Question 1: On January 1, 2013, Jennings, Inc. issued $400,000, 10-year, 10% bonds for $360,000. The bonds pay interest on June 30 and December 31. The market rate is 10%. How much is the interest expense on the bonds for the first interest payment on June 30, 2013?

A. $43,200

B. $21,600

C. $18,000

D. $36,000

Question 2: On January 1, 2013, Andrew Company issues $320,000, 15 year, 8% bonds (paying semiannual interest) for $360,800, when the annual market rate of interest is 6%. If the company uses the effective interest method of amortization, the journal entry to record the semi-annual interest on June 30 will include a:

A. Debit to interest expense for $12,000

B. Debit to interest expense for $21,528

C. Credit to cash for $24,000

D. Debit to premium on bonds payable for $1,976

Explanation / Answer

Answer of Question 1:

$18,000 is the interest expenses on the bonds for first interest payment on June 30, 2013.

Here is the working and calculation:

In the question, the bonds are sold at a discount

Company received from selling these bonds only $360,000. Thus, the bonds are sold at a discount of $40,000 ($400,000 face value minus proceeds of $360,000)

Interest expense calculations
Every six months, Jennings, Inc will naturally have to pay its bondholders cash coupons of $20,000.

Cash Interest = $400,000 x 10% x ½ = $20,000

This is clearly interest expense. However, it isn't the only amount recorded as interest expense on a bond sold at a discount.

The discount on the bonds of $40,000 is an additional cost of financing.

The discount is amortized into interest expense over time.

To calculate the interest expense for the first period,

we take the $360,000 carrying value of the bonds and multiply it by half the yield-to-maturity.

This results in $360,000 x 0.10 x ½ = $18,000 of interest expense for the first semiannual period.

The actual cash interest paid was only $5,000 -- the coupon multiplied by the bond's face value. However, interest expense also includes the $558.39 of amortized discount in the first six months.

Answer of question 2:

Interest Expenses to be recorded = $360,800 x 6% x ½ = $10,824

Cash Interest to be paid to bond holders = $320,000 x 8% x ½ = $12,800

Thus, interest expense is recorded as $10,824 for the first period, while $1976 ($12,800 - $10,824) is recorded as premium amortization

Hence the journal entry to record the semi-annual interest on June 30 will be

D. Debit to premium on bonds payable for $1,976

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