Question

The case can be found in the link "end of chapter materials" in the Chapter 14 reading link under Required Resources.

CA14-1.  

(Bond Theory: Balance Sheet Presentations, Interest Rate, Premium)

On January 1, 2017, Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1. The following are three presentations of the long-term liability section of the balance sheet that might be used for these bonds at the issue date.

1.	Bonds payable (maturing January 1, 2037)	$1,000,000
	Unamortized premium on bonds payable	85,800
	Total bond liability	$1,085,800
2.	Bonds payable—principal (face value $1,000,000 maturing January 1, 2037)	$  142,050a (Links to an external site.)
	Bonds payable—interest (semiannual payment $55,000)	943,750b (Links to an external site.)
	Total bond liability	$1,085,800
3.	Bonds payable—principal (maturing January 1, 2037)	$1,000,000
	Bonds payable—interest ($55,000 per period for 40 periods)	2,200,000
	Total bond liability	$3,200,000

Instructions

(a)  

Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown above for these bonds.

(b)  

Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000.

(c)  Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose:

• 1.The coupon or nominal rate.
• 2.The effective or yield rate at date of issue.

(d)  

If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest?

(AICPA adapted)

Answer 1

Part A

This presentation of information in this disintegrated manner helps investors to know the cost of bonds. It is a balance sheet presentation which is quite common. The maturity value which is face value of bonds is presented along with the fair market value (issue price). As the fair market value is used as a primary source of information, it is in accordance to GAAP policy.

In case of second presentation, there is disintegration of bonds payable principal and bonds payable interest. It presents these two obligations related to the bonds, making payment of semi-annual payments and maturity value. Moreover, it includes interest which is likely to accrue over the life time of bond.

In case of third presentation, there is disintegration of bonds payable principal and bonds payable interest. The total bond payable liability is divided into these two parts. It presents the total amount of interest incurred on issuance of bonds.

Part B

There is payment of specific amount at maturity and payment of interest at a predefined rate at the regular interval in case of bonds. Here, bond is expected to have higher coupon rate compared to market interest rate and thus bonds are likely to higher yield. Here investors are likely to receive payment of $55000 twice in a year along with 1000000 on the maturity date.

Part C

1. The coupon or nominal rate : the application of coupon rate helps to get the face value of bonds. Moreover, the due interest payments can be determined on its basis. There is decrease in interest expense due to amortization.

2. The effective or yield rate at date of issue: it is the interest rate earned by the holders of bonds. In case of bond issued at premium, effective interest is lower than the coupon rate and the opposite is case in situation of bond issued at discount. Interest expense is calculated by multiplying effective interest rate to carrying value of the bond.

Part D

The current market rate of interest helps in deriving the value that should be invested in the current scenario. However, there is an inverse relationship between the market rate and interest. There is an increase in interest when the market rate is lower than the rate was at issue. While there is a decrease in interest when the market rate is higher than the rate was at issue.