Question

Fuzzy Monkey Technologies, Inc., purchased as a short-term investment $80 million of 8% bonds, dated January 1, on January 1, 2021. Management intends to include the investment in a short-term, active trading portfolio. For bonds of similar risk and maturity the market yield was 10%. The price paid for the bonds was $66 million. Interest is received semiannually on June 30 and December 31. Due to changing market conditions, the fair value of the bonds at December 31, 2021, was $70 million.

Required:
1. to 3. Prepare the relevant journal entries on the respective dates (record the interest at the effective rate).
4-a. At what amount will Fuzzy Monkey report its investment in the December 31, 2021 balance sheet?
4-b. Prepare any entry necessary to achieve this reporting objective.
5. How would Fuzzy Monkey's 2021 statement of cash flows be affected by this investment? (If more than one approach is possible, indicate the one that is most likely.)

Answer 1

1. Journal entries

Date	Account	Debit	Credit
Purchase of bonds
01-01-2021	Investment in bonds	80000000
	Discount on bond		14000000
	Cash		66000000
Receipt on semi annual interest
06-30-2021	Cash	3200000
	Discount on bond	100000
	Interest revenue		3300000
12-31-2021	Cash	3200000
	Discount on bond	105000
	Interest revenue		3305000

Calculation of interest revenue and discount amortization

Date	Int @ 8%	Effective Int	Discount amortization	Balance
	(80 million * 8% * 6/12)	(Balance * 10% * 6/12)	(Effective Int - Int)
01-01-2021				66000000
06-30-2021	3200000	3300000	100000	66100000
12-31-2021	3200000	3305000	105000	66205000

4-a. Amount reported in balance sheet

Fuzzy Monkey will report the investment at its fair value of $70 million. The investment is classified as a trading security (short term) hence reporting will be at fair value.

4-b. Journal entry

Account	Debit	Credit
Fair Value adjusted	3795000
Unrealised gain		3795000

Calculation of unrealised gain:

Investment amount	80000000
Less: Discount on bond	-14000000
Add: Amortization on 6/30/21	100000
Add: Amortization on 12/31/21	105000
Balance on 12/31/21	66205000
Fair value on 12/31/21	70000000
Unrealised gain	3795000

5. Effect on cash flow statement

Fuzzy Monkey will report cash flow from interest of $6.4 million ($3.2 million + $3.2 million) in 'cash flow from operating activities'.

If indirect method is used Interest income of $6605000 ($3300000 + $3305000) in its net income. Accordingly an adjustment entry will be made for -$205000 ($6605000 - $6400000). This would result in net effect of cash flow of $6.4 million from operating activities.

Amount spent on purchase of bonds of $66 million will be shown under the head 'cash flow from investing activities'.