Problem:

March 1
Issued $800,000 face value Titus Co. second mortgage, 8% bonds for $872,160, including accrued interest. Interest is payable semiannually on December 1 and June 1 with the bonds maturing 10 years from this past December 1. The bonds are callable at 102.

Prepare the necessary journal entries to record the following transactions relating to the long-term issuance of bonds of Titus Co.:

What I have so far...

Bonds Pay. 872160
Premium on Bonds Pay. 72160
Cash 800000

...I don't need to schedule a schedule of effective interest do I? I also had a problem similar to this and it required me to figure out the effective interest. But I'm a little confused as to how many periods there are. Are there 20 because of the ten years and the semi-annual payments?? I need some help

morgaine300

This unfortunately is a bit more complicated than you're trying to make it. First, let's straighten up a couple of errors in the entry that don't even get into the complicated part. The bonds payable account is always, always, always the amount that will be paid back when the bonds mature. And what is paid back is the face value, not the amount they were issued for. Also, if they were issued for 872,160, then how much did you get in cash? How do you only get $800,000 in cash if you issued the bonds for higher than that?

OK, now the accrued interest. You're not taking this into account. The 72,160 is not all premium, because there's accrued interest making an effect on that extra amount. Notice that they are issuing them between interest pay dates? This will sound a little weird, but when the interest is paid on June 1, the company will pay the entire 6 months worth of interest. However, there's really only interest for March 1 to June 1, right? Well, if the company pays 6 months, that's too much. So the bondholders have to pay the difference to the company ahead of time. i.e. if they were one month into a semi-annual period, they would have to pay one month's worth of interest to the company. Then five months later when the company pays the interest out, they'll pay an entire six months. So the bondholders get that month back, and it goes against what the company got ahead of time, and it all works out in the end. (Really, it does.)

So you need to look at how far into the semi-annual period they are, and therefore how much did the bondholders have to pay to the company? That portion of the issuance amount is that interest. Then when you subtract that out, the rest is the premium.

So what do you do with that interest that was paid up front? Credit the interest expense. Yes, that would be negative. When the entire six months is paid later, you debit the expense for the whole thing, it'll go against that negative and it'll net to the correct amount. I've got it in my head that there's another way of handling that interest but not thinking what it is and I'm not finding another method in the book I'm looking at. You may need to check your book on that one.

And yes, it's 20 periods. If you don't have to do effective interest method, then you're doing straight-line. If you have to amortize the interest semi-annually with the interest payment, then you'll want to take your premium and divide by the 20 periods, into semi-annual periods. Um, except for that first period, cause it's only a partial period. (Just to make things more fun.)

Did you have another question on the effective interest method?

Oh, and when you do entries here, you need to put DR or CR on them so we know what you're actually doing.

wongkey

So I would do...
CR DR
Cash (800,000 x 1.02) + (800,000 x .08 x (3/6) 848,000
Bonds Payable 800,000
Premium on Bonds Payable (80,000 - 32,000) 48,000
Bond Interest Expense (800,000 x .08 x (3/6) 32,000

Is this the right method? I know it's not the right answer, but am I going in the right direction? Hmmm and if I'm doing something wrong, then what am I doing wrong again?

morgaine300

800,000 x .08 x 3/12 - the interest is quoted annually and therefore 3 months out of 12, not 3 months out of semi-annual

If you issued the bonds for 872,160, then you issued them for 872,160. You can't change that. How much cash did you get? You don't need to calculate the cash -- they gave it to you.

I still don't know what you're debited & crediting. Putting DR & CR at the top of your entry doesn't help because it's not in columns. You have to list it in front of each account.