A partial bond amortization schedule follows for Hwee Corporation:
Instructions
(a) Fill in the missing amounts for items [1] to [7].
(b) What is the face value of the bonds?
(c) Were the bonds issued at a discount or at a premium?
(d) What is the coupon interest rate on the bonds? The market interest rate?
(e) Explain why interest expense is greater than interest paid.
(f) Explain why interest expense will increase each period.
(g) What will be the bonds’ carrying amount on their maturity date?
SOLUTION
(a) [1] $25,000 + $2,768 = $27,768
[2] $74,387 – $2,768 = $71,619
[3] $27,851 – $25,000 = $2,851
[4] $928,381 + $2,851[3] = $931,232 or $1,000,000 – $68,768
[5] $25,000 same as previous semi-annual payments
[6] $27,937 – $25,000 = $2,937
[7] $68,768 – $2,937 [6] = $65,831
$1,000,000 face value ($925,613 carrying amount plus unamortized discount $74,387 at issue date)
The bonds were issued at a discount as the carrying amount of $925,613 is lower than the face value of the bond $1,000,000 at the issue date.
Coupon interest rate: Semi-annual payments are $25,000 × 2 divided by the face value $1,000,000 = 5% per year
Market interest rate: Interest expense April 30 (item [1] of part (a) $27,768) divided by carrying amount at issue date $925,613 = 3% × 2 = annual rate of 6%
The effective rate of interest of 6% is greater than the coupon rate. Interest expense is calculated using the market rate of interest and cash interest paid is calculated using the coupon rate. Therefore, interest expense is greater than cash interest paid.
Interest expense is calculated by multiplying the carrying value of the bonds by the market rate of interest. With each semi-annual payment, the carrying amount of the bonds increases, from the semi-annual amortization of the discount, and consequently, the amount of interest expense increases.
The carrying amount of the bonds will be equal to the face value of the bonds of $1,000,000 as the entire amount of the discount will have been amortized.