Bonds payable-record issuance and premium amortization. Kaye Co. issued $1 million face amount of 11% 20-year bonds on April 1,2004. The bonds pay interest on an annual basis on March 31 each year.

Required:

a. Assume that market interest rates were slightly lower than 11% when the bonds were sold. Would the proceeds from the bond issue have been more than, less than, or equal to the face amount? Explain.

b. Independent of your answer to part a, assume that the proceeds were $1,080,000. Use the horizontal model (or write the journal entry) to show the effect of issuing the bonds.

c. Calculate the interest expense that Kaye Co. will show with respect to these bonds in its income statement for the fiscal year ended September 30, 2004, assuming that the premium of $80,000 is amortized on a straight-line basis.

Cash proceeds would be higher than face amount.

Bond issuance:

Dr cash $1,080,000

Cr bonds payable $1,000,000

Cr premium on bonds payable ($1,080,000-$1,000,000) $80,000

$57,400

Explanation:

If the market interest rate were slightly lower than 11% coupon rate, the cash proceeds from the bonds would be higher than face amount as a lower market rate is used as a discount rate in calculating the present value, in other words, the lower the discount rate, the higher the present value as further shown below.

Assume market rate is 10.5%

cash proceeds=-pv (rate, nper, pmt, fv)

rate is 10.5%

nper is 20 years

pmt = $1,000,000*11%=$110,000

fv is $1000,000

=-pv (10.5%,20,110000,1000000) = $1,041,154.54

amortization (annually) = $80,000/20=$4000

Amortization for six months=$4,000*6/12=$2,000

coupon=$1,080,000*11%*6/12=$ 59,400.00

Interest expense=coupon - premium amortization=$ 59,400.00-$2,000.00=$57,400