1. Liabilities at September 30, 2011

Bonds payable (face amount) $160,000,000

Less: discount 20,000,000

Initial balance, January 1, 2011 $140,000,000

June 30, 2011 discount amortization 400,000*

Sept. 30, 2011 discount amortization 212,000**

Sept. 30, 2011 net bonds payable $140,612,000

Interest payable ** $4,000,000

2. Interest expense for year ended September 30, 2011

June 30, 2011 interest expense $ 8,400,000*

September 30, 2011 interest expense 4,212,000**

Interest expense for fiscal 2011 $12,612,000

3. Statement of cash flows for year ended September 30, 2011

Baddour would report the cash inflow of $140,000,000*** from the sale of the bonds as a cash flow from financing activities in its statement of cash flows.

The $8,000,000* cash interest paid is a cash outflow from operating activities because interest is an income statement (operating) item.

Problem 14-2 (concluded)

Calculations:

January 1, 2011***

Cash(price: given) 140,000,000 Discount on bonds (difference) 20,000,000 Bonds payable (face amount) 160,000,000

June 30, 2011*

Interest expense(6% x $140,000,000)8,400,000

Discount on bonds payable (difference) 400,000 Cash(5% x $160,000,000) 8,000,000

September 30, 2011**

Interest expense(6% x [$140,000,000 + 400,000] x 3/6)4,212,000 Discount on bonds payable (difference) 212,000 Interest payable (5% x $160,000,000 x 3/6) 4,000,000

Problem 14-3

Requirement 1

Cash Effective Increase in Outstanding Payment Interest Balance Balance 4.5% x Face Amount 5% x Outstanding Balance

96,768

1 4,500 .05 (96,768) = 4,838 338 97,106

2 4,500 .05 (97,106) = 4,855 355 97,461

3 4,500 .05 (97,461) = 4,873 373 97,834

4 4,500 .05 (97,834) = 4,892 392 98,226

5 4,500 .05 (98,226) = 4,911 411 98,637

6 4,500 .05 (98,637) = 4,932 432 99,069

7 4,500 .05 (99,069) = 4,953 453 99,522

8 4,500 .05 (99,522) = 4,978* 478 100,000

36,000 39,232 3,232

^* rounded.

Requirement 2

Cash Recorded Increase in Outstanding Payment Interest Balance Balance 4.5% x Face Amount Cash plus Discount Reduction $3,232 ÷ 8

96,768 1 4,500 (4,500 + 404) = 4,904 404 97,172 2 4,500 (4,500 + 404) = 4,904 404 97,576 3 4,500 (4,500 + 404) = 4,904 404 97,980 4 4,500 (4,500 + 404) = 4,904 404 98,384 5 4,500 (4,500 + 404) = 4,904 404 98,788 6 4,500 (4,500 + 404) = 4,904 404 99,192 7 4,500 (4,500 + 404) = 4,904 404 99,596

8 4,500 (4,500 + 404) = 4,904 404 100,000

36,000 39,232 3,232

Problem 14-3 (continued)

Requirement 3

(effective interest)

Interest expense(5% x $98,226)4,911 Discount on bonds payable (difference) 411 Cash(4.5% x $100,000) 4,500

(straight-line)

Interest expense($4,500 + 404)4,904 Discount on bonds payable ($3,232 ÷ 8) 404 Cash(4.5% x $100,000) 4,500

Requirement 4

By the straight-line method, a company determines interest indirectly by allocating a discount or a premium equally to each period over the term to maturity. This is allowed if doing so produces results that are not materially different from the interest method. The decision should be guided by whether the straight-line method would tend to mislead investors and creditors in the particular circumstance.

Allocating the discount or premium equally over the life of the bonds by the straight-line method results in an unchanging dollar amount of interest each period. By the straight-line method, the amount of the discount to be reduced periodically is calculated, and the effective interest is the “plug” figure.

Unchanging dollar amounts like these are not produced when the effective interest approach is used. By that approach, the dollar amounts of interest vary over the term to maturity because the percentage rate of interest remains constant, but is applied to a changing debt balance.

Remember that the “straight-line method,” is not an alternative method of determining interest in a conceptual sense, but is an application of the materiality concept. The appropriate application of GAAP, the effective interest method, is by-passed as a practical expediency in situations when doing so has no “material” effect on the results.

Problem 14-3 (concluded)

Requirement 5

The amortization schedule in requirement 1 gives us the answer: $9,864. The outstanding debt balance after the June 30, 2013, interest payment (line 5) is the present value at that time ($98,637) of the remaining payments. Since $10,000 face amount of the bonds is 10% of the entire issue, we take 10% of the table amount.

This can be confirmed by calculating the present value:

Interest $450^¥ x 2.72325 ^* = $1,225 Principal $10,000 x 0.86384 ^** = 8,638

Present value (price) of the bonds $9,864 (rounded)

^¥ 4.5% x $10,000

^* present value of an ordinary annuity of $1: n=3, i=5% (Table 4)

^** present value of $1: n=3, i=5% (Table 2)

Problem 14-4

Requirement 1

$8,000,000 (outstanding balance at maturity)

Requirement 2

$6,627,273 (outstanding balance at sale date)

Requirement 3

20 years (40 semiannual periods)

Requirement 4

At the effective interest rate (By the alternative straight-line approach, interest would be the same amount each period)

Requirement 5

8% [($320,000 ÷ $8,000,000) x 2]

Requirement 6

10% [($331,364 ÷ $6,627,273) x 2]

Requirement 7

$12,800,000 ($320,000 x 40)

Requirement 8

$14,172,727 ($12,800,000* + [$8,000,000 – 6,627,273])

(Total cash interest plus the discount)

*$320,000 x 40

Problem 14-5

Requirement 1

Interest $3,600,000^¥ x 6.46321 ^* = $23,267,556 Principal $80,000,000 x 0.67684 ^** = 54,147,200 Present value (price) of the bonds $77,414,756

^¥ 4.5% x $80,000,000

^* present value of an ordinary annuity of $1: n=8, i=5% (Table 4)

^** present value of $1: n=8, i=5% (Table 2)

Requirement 2

(a) Cromley

Cash Effective Increase in Outstanding Payment Interest Balance Balance 4.5% x Face Amount 5% x Outstanding Balance Discount Reduction

77,414,756 1 3,600,000 .05 (77,414,756) = 3,870,738 270,738 77,685,494 2 3,600,000 .05 (77,685,494) = 3,884,275 284,275 77,969,769 3 3,600,000 .05 (77,969,769) = 3,898,488 298,488 78,268,257 4 3,600,000 .05 (78,268,257) = 3,913,413 313,413 78,581,670 5 3,600,000 .05 (78,581,670) = 3,929,084 329,084 78,910,754 6 3,600,000 .05 (78,910,754) = 3,945,538 345,538 79,256,292 7 3,600,000 .05 (79,256,292) = 3,962,815 362,815 79,619,107

8 3,600,000 .05 (79,619,107) = 3,980,893* 380,893 80,000,000 28,800,000 31,385,244 2,585,244

^* rounded.

Problem 14-5 (continued)

(b) Barnwell

Cash Effective Increase in Outstanding Payment Interest Balance Balance 4.5% x Face Amount 5% x Outstanding Balance Discount Reduction

77,415 1 3,600 .05 (77,415) = 3,871 271 77,686 2 3,600 .05 (77,686) = 3,884 284 77,970 3 3,600 .05 (77,970) = 3,899 299 78,269 4 3,600 .05 (78,269) = 3,913 313 78,582 5 3,600 .05 (78,582) = 3,929 329 78,911 6 3,600 .05 (78,911) = 3,946 346 79,257 7 3,600 .05 (79,257) = 3,963 363 79,620

8 3,600 .05 (79,620) = 3,980 * 380 80,000

28,800 31,385 2,585

*rounded

Requirement 3

February 1, 2011 (Cromley)

Cash(price determined above) 77,414,756 Discount on bonds payable (difference) 2,585,244 Bonds payable (face amount) 80,000,000

February 1, 2011 (Barnwell)

Bond investment (face amount) 80,000 Discount on bond investment (difference) 2,585 Cash(price paid) 77,415

Problem 14-5 (continued)

Requirement 4

July 31, 2011 (Cromley)

Interest expense(from schedule)3,870,738 Discount on bonds payable(from schedule) 270,738 Cash(from schedule) 3,600,000

July 31, 2011 (Barnwell)

Cash(from schedule) 3,600 Discount on bond investment(from schedule)271 Interest revenue(from schedule)3,871

December 31, 2011 (Cromley)

Interest expense(⁵/₆x $3,884,275)3,236,896 Discount on bonds payable (⁵/₆x $284,275) 236,896 Interest payable(⁵/₆x $3,600,000) 3,000,000

December 31, 2011 (Barnwell)

Interest receivable(⁵/₆x $3,600) 3,000 Discount on bond investment (⁵/₆x $284) 237 Interest revenue(⁵/₆x $3,884)3,237

January 31, 2012 (Cromley)

Interest expense(¹/₆x $3,884,275)647,379 Interest payable(from adjusting entry above) 3,000,000 Discount on bonds payable (¹/₆x $284,275) 47,379 Cash(stated rate x face amount) 3,600,000

January 31, 2012 (Barnwell)

Cash(stated rate x face amount) 3,600 Discount on bond investment (¹/₆x $284) 47 Interest receivable(from adjusting entry above) 3,000 Interest revenue(¹/₆x $3,884)647

Problem 14-5 (concluded)

July 31, 2012 (Cromley)

Interest expense(from schedule)3,898,488 Discount on bonds payable(from schedule) 298,488 Cash(from schedule) 3,600,000

July 31, 2012 (Barnwell)

Cash(from schedule) 3,600 Discount on bond investment(from schedule)299 Interest revenue(from schedule)3,899

December 31, 2012 (Cromley)

Interest expense(⁵/₆x $3,913,413)3,261,177 Discount on bonds payable (⁵/₆x $313,413) 261,177 Interest payable(⁵/₆x $3,600,000) 3,000,000

December 31, 2012 (Barnwell)

Interest receivable(⁵/₆x $3,600) 3,000 Discount on bond investment (⁵/₆x $313) 261 Interest revenue(⁵/₆x $3,913)3,261

January 31, 2013 (Cromley)

Interest expense(¹/₆x $3,913,413)652,236* Interest payable(from adjusting entry above) 3,000,000 Discount on bonds payable (¹/₆x $313,413) 52,236* Cash(stated rate x face amount) 3,600,000

January 31, 2013 (Barnwell)

Cash(stated rate x face amount) 3,600 Discount on bond investment (¹/₆x $313) 52 Interest receivable(from adjusting entry above) 3,000 Interest revenue(¹/₆x $3,913)652

*rounded

Problem 14-6

Requirement 1

April 1, 2011 (Western)

Cash($29,300,000 + [¹/₁₂x 12% x $30,000,000]) 29,600,000 Discount on bonds payable ($30 million – $29.3 million) 700,000 Bonds payable (face amount) 30,000,000 Interest payable (¹/₁₂x 12% x $30,000,000) 300,000

April 1, 2011 (Stillworth)

Bond investment (face amount) 30,000 Interest receivable(¹/₁₂x 12% x $30,000) 300 Discount on bond investment ($30,000 – $29,300) 700 Cash($29,300 + [¹/₁₂x 12% x $30,000]) 29,600

Alternative: Some accountants prefer to credit (debit) interest expense (revenue), rather than interest payable (receivable), when bonds are sold (purchased).

April 1, 2011 (Western)

Cash ($29,300,000 + [¹/₁₂ x 12% x $30,000,000]) 29,600,000 Discount on bonds payable ($30 million – $29.3 million) 700,000 Bonds payable (face amount) 30,000,000 Interest expense (¹/₁₂ x 12% x $30,000,000) 300,000

April 1, 2011 (Stillworth)

Bond investment (face amount) 30,000 Interest revenue (¹/₁₂ x 12% x $30,000) 300 Discount on bond investment ($30,000 – $29,300) 700 Cash ($29,300 + [¹/₁₂ x 12% x $30,000]) 29,600

If the alternate entries are used, entries at the next interest date would require simply a debit (credit) to interest expense (revenue) for the full interest. The interest accounts would then reflect the same net debit of five months' interest.

Problem 14-6 (continued)

Requirement 2

The original maturity of the bonds was 3 years, or 36 months. But since the bonds weren’t sold until one month after they were dated, they are outstanding for only 35 months. Straight-line amortization, then, is $700,000 ÷ 35 months = $20,000 per month for Western (and $700 ÷ 35 months = $20 per month for Stillworth’s investment).

August 31, 2011 (Western)

Interest expense($1,800,000 + 100,000 – 300,000)1,600,000 Interest payable (accrued interest from above) 300,000 Discount on bonds payable($20,000 x 5 months) 100,000 Cash($30,000,000 x 12% x⁶/₁₂) 1,800,000

August 31, 2011 (Stillworth)

Cash($30,000 x 12% x⁶/₁₂) 1,800 Discount on bond investment($20 x 5 months) 100 Interest receivable (accrued interest from above) 300 Interest revenue($1,800 + 100 – 300)1,600