On January 1, 2010, Sunshine company issues bonds maturing in 10 years. The par value of the bonds is $500,000, the annual coupon rate is 4%, and the compounding period is annually. The market initially prices these bonds using market interest rate 6%. The market interest rate on December 31, 2010 was 7%.Were the bonds issued at par, at discount or at premium? Why? (3 points)

Calculate the issue price. (4 points)

Record journal entry on the date of issuance. (3 points)

Calculate the interest expense on Dec 31, 2010. (2 points)

Record journal entry on the interest expense on Dec 31, 2010. (3 points)

Will the interest expense increase or decrease over the years? Why? (3 point)

Record journal entry on Dec 31, 2019 for the final redemption (2 point)

Answer and Explanation:

a. The bonds is issued at a discount, since the coupon rate is lower than the interest rate on the market.

b. Par value = $500,000.

Annual coupon = Par value of bonds × Coupon rate

= $500,000 × 4 %

= $20,000

Interest rate = 6%

n = 10

Present value of an annuity 6%, n = 10 = ((1 - ( 1 ÷ 1.06 ) × 10) ÷ 0.06)

= 7.3601

Present value 6%, n = 10 = (1 ÷ 1.06) × 10

= 0.5584

Issue price of the bonds = Annual coupon × Present value of an annuity + Par value of bonds × Present value

= $20,000 × 7.3601 + $500,000 × 0.5584

= $147,202 + $279,200

= $426,402

3.The Journal entry is shown below:-

Cash Dr, 426,402  

     To Discount on Bonds Payable $73,598  

      To Bonds Payable $500,000

Being cash is recorded)

4. Interest expense for the year ended December 31, 2010 = Issue price of the bonds × Interest rate

= $426,402 × 7%

= $29,848.14

5. The Journal entry is shown below:-

Interest Expense Dr, 29,848  

Discount on Bonds Payable Dr, 9,848  

      To Cash $20,000

(Being interest expenses is recorded)

6. Over the years the interest rate would rise as the bonds were issued at a discount.

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