BONDS ISSUED BETWEEN INTEREST PAYMENT DATES:

A STUDENT PROJECT Timothy B. Forsyth, Ph.D., Senior Associate Dean

Walker College of Business

Appalachian State University Boone, NC 28608

828-262-6205 Phone

828-262-6640 Fax

*Philip R. Witmer, Ph.D., Professor of Accounting

Walker College of Business Appalachian State University

Boone, NC 28608

828-262-6232 Phone

828-262-6640 Fax

witmerpr@appstate.edu

*Corresponding author

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INTRODUCTION TO THE PROJECT

Generally accepted accounting principles (GAAP) require that bonds issued by a company be amortized using the effective interest method, unless the straight-line method is not materially different (Accounting Standards Codification 835-30-35). Intermediate accounting textbooks make this point clear and examples, exercises and problems are consistent with that requirement. That is, until the topic moves to bonds that have been issued after the intended issue date or between interest payment dates and therefore interest has accrued. When the topic of bonds issued between interest payment dates is addressed, the examples suddenly and inexplicably begin adopting the straight-line method. The reasons for this shift are legitimate, given the complexities of computing the amortization for partial compounding periods. While some students may not fully understand the difference between straight-line and effective interest methods of amortization, the perceptive student can be puzzled by the inconsistency. We believe that the approach taken by the textbooks is perfectly understandable, but that this provides an opportunity to deepen the students’ understanding of bonds and the difference between effective interest and straight-line amortization.

In this paper, we present a project that can be assigned in the intermediate class which focuses on the difference between these two interest amortization methods and, at the same time, provides an opportunity to do additional research in the FASB codification and allows the student to see a materiality decision in a particular context. It also provides a spreadsheet that can be used by the student to create an amortization table using the effective interest method.

A DESCRIPTION OF THE PROJECT

In the project presented in this paper, the student is placed in the role of a staff accountant of a firm of certified public accountants, whose client has issued a bond with accrued interest, in that it was issued after the date of the bond. The client has recorded interest using the straight-line method. In addition, the client has redeemed a portion of the original bond issue, thus creating some additional complexities for the student. The students are asked to recreate the journal entries the client would have created, using straight-line amortization, for selected transactions. They are also asked to create the same transactions using the effective-interest method. Further, they are then asked to research the FASB codification to determine which method is preferred under current generally accepted accounting principles. There are some key computer files, which will need to be accessed to apply this case and each will be described in turn, beginning with the Student Assignment.docx (See Appendix 1).

This is the document the student (or student team) will receive. Students are allowed to work as an individual or with one other partner and each work unit will receive the Student Assignment. In order to encourage independent work, eight different versions of the assignment were created by altering some of the variables in the project. The variables that are manipulated are transaction date, face amount of bonds issued, stated interest rate, issue price (stated as a percentage of par), the date and amount of bonds redeemed and the market price at date of redemption (again, as a percentage of par). The following summarizes the variables for the eight versions used in the administration of the project:

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The variables that were not altered and were consistent across all versions of the project were the date of the bonds (January 1, 2015), the maturity date of the bonds (December 31, 2024), and the interest payment dates (each December 31). As can be seen by reference to the included Student Assignment.docx, an additional version was created for use in this paper. Specifically, $1,500,000 of bonds were taken to market on October 1, 2015 at 101.3 (or $1,519,500).The stated rate of interest on the bonds was 7%. On April 1, 2017, $600,000 of the bonds were redeemed at a price of 102, plus accrued interest (or $622,500).

In each of the versions, transaction dates selected were as of the beginning of the month, in order to simplify the students’ calculations for the straight-line amortization method. (The Student Template calculates accrued interest on the basis of number of days for the effective interest method.)

For purposes here, I have highlighted each of the variables on the Student Assignment.docx. Obviously they would not be highlighted on the version the students receive. To assist the student in the preparation of the journal entries using the effective interest method, we have prepared and make available to the students an Excel spreadsheet, entitled Student Project Template.xlsx.

This spreadsheet will generate an amortization table, with a partial initial compounding period. The students will have been introduced to the spreadsheet in class with some instruction on updating the spreadsheet. The variables need to be entered into the Input Variables block in the upper left section of the spreadsheet, as indicated by the arrow:

Version  1 Version  2 Version  3 Version  4 Version  5 Version  6 Version  7 Version  8Face  amount 750,000           600,000           900,000           800,000           1,000,000     700,000           1,100,000     650,000          Coupon  rate 6% 4% 5% 4% 6% 5% 4% 3%Issue  date 5/1/2015 8/1/2015 9/1/2015 2/1/2015 4/1/2015 3/1/2015 7/1/2015 6/1/2015Market  price  -­‐  at  issue 103 106 97 101 102 98 102 99Face  of  redeemed  bonds 300,000           200,000           700,000           500,000           700,000           350,000           350,000           400,000          Redemption  date 4/1/2017 3/1/2017 6/1/2017 9/1/2017 2/1/2017 3/1/2017 12/1/2017 5/1/2017Market  price  -­‐  at  redemption 102 105 103 98 101 101 101.5 102

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Specifically, the maturity date of 12/31/2024, the number of interest payments per year (1), the face amount of the bonds issued ($1,500,000), the stated interest rate (7), the market value of the bonds (101.3% of $1,500,000, or $1,519,500) and the date of the transaction (10/1/2015). Note that only cells in this block should be edited. Cells in the rest of the worksheet will be updated automatically, with the help of Excel’s Goal Seek function.

Having entered those variables, the amortization table of the appropriate size will fill in to the right. However, it is probably not correct at this point, as it is amortizing using a yield from a previous use of the spreadsheet, which will be evident if the spreadsheet does not properly amortize to the face amount of the bonds. In order to update the spreadsheet, we will need to invoke the Goal Seek function in Excel. The inputs for the Goal Seek dialog box are provided in the Goal Seek Inputs box directly below the Input Variables box.

Before invoking the Goal Seek function, make the bottom right cell in the amortization table (cell N13, in this case) the active cell. Then invoke the Goal Seek function as follows. Select the Data tab in the Excel ribbon, and then the What-if Analysis in the drop down menu, from which you will select the Goal Seek. This will present the Goal Seek dialog box, as illustrated below. If you’ve properly made cell N13 active, it should already appear in the first box. Then, following the guidance in the Goal Seek Inputs box, enter 1500000 and g20 in the remaining spaces, respectively. Hit OK once to accept the variables, and then again to close the dialog box. The amortization schedule should now be updated and properly amortize to face value.

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You will notice that, in addition to the 100% tab we have been working in, there are two additional tabs in the spreadsheet. They are the Redemption Table and the Remainder Table. Given that the client issued bonds and then redeemed a portion of the bonds and then continued to service the remaining portion of the bonds, we will need three separate amortization tables to complete this project, one for the entire bond issue (the 100% tab we have been working with) and two complimentary subsets of that table. That is, one for the $600,000 bonds that were redeemed (or 40% of the original issue) and a third for the $900,000 bonds that are still outstanding and must be serviced (or 60% of the original issue).

These two amortization tables will have to be created in the same way we created the 100% table. While the two tables will reflect complimentary subsets of the original issue, the variables in effect at the date of issue apply to both remaining amortization tables. That is, both subsets of the whole were also issued on October 1, 2015 at 101.3. This should serve as a subtle reminder to the students that, unless the client has adopted the fair value option, bonds continue to be valued on the balance sheet using the historical cost principle. That is the values in effect at the issue date continue to drive the amortization of the premium or discount and therefore the balance sheet valuation at any balance sheet date.

Recording the Bond Issuance and the First Interest Payment

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The worksheet makes many computations based upon the variables entered in the Input Variables block. Some of those computations are presented in the Worksheet Calculations block (which appears below the Goal Seek Inputs block). A few of those calculations provide information for the preparation of the issuance of the bonds. Specifically, the amount of cash received represents the market value of the bonds plus the interest that has accrued since the statutory issue date, in this case January 1, 2015, and will be debited to cash. The accrued interest amount will be part of the entry and can be credited to Interest Payable or Interest Expense.

On the first interest payment date, students will be accessing information from the first compounding period, which in this case is a partial period. In this case, we will be amortizing the premium for a partial period in the amount of $394.20, taken directly from the amortization table. Of course cash will be credited for the statutory interest payment amount, in this case $105,000, causing a debit to interest expense of $104,605.80. That debit to interest expense netted against the credit to Interest Expense for the accrued interest, of $78,821.92 results in a net debit to the Interest Expense account of $25,783.88, which is the amount that appears in the Interest column of the amortization table and represents the actual interest incurred during this partial period, in this case October 1 through December 31, 2015. The amount in the Cash Paid Column of the amortization table is an unfamiliar number, because it represents the netting of the receipt of accrued interest on the actual bond issuance date of $78,821.92 and the contractual interest paid on December 31 of $105,000, of the $26,178.08 that appears on the amortization table.

For example, the entries to record the issuance of the bond and the first payment of interest for the variables presented in this paper would be as follows:

Of course, if Interest Payable had been credited in the first entry rather than Interest

Expense, it would have to be debited in the December 31 entry, thereby resulting in a debit to Interest Expense of $26,178.08. In either case, the net effect on Interest Expense for the period would be the same.

We generally provide students with some sample bond issuances to let them practice updating the Student Project Template.xlsx worksheet and recording the bond issuance and the first interest payment to make sure they arrive at the correct interest expense amount for the first partial period.

Oct  1,  2015 Cash 1,598,321.92          Bonds  payable 1,500,000.00          Premium  on  bonds  payable 19,500.00                      Interest  expense 78,821.92                      

Dec  31,  2015 Interest  expense 104,605.80                  Premium  on  bonds  payable 394.20                                  

Cash 105,000.00                  

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To facilitate grading the project, an additional spreadsheet has been created, entitled Bond Project Solution.xlsx.

Whereas the Student Project Template.xlsx is rather flexible in that it can accommodate up to 1,000 compounding periods, the Bond Project Solution.xlsx spreadsheet was written specifically with this project in mind and therefore is rather rigid. This spreadsheet automatically prepares the required journal entries for both the straight-line method and the effective interest method.

First of all, it contains the same three tabs for the three required amortization tables as the Student Project Template.xlsx spreadsheet. It also contains a Variables Control tab, which is where the variables for the particular version of the project are entered. To create a solution for a particular version of the project, go to the Variable Control tab and enter a variable for each of the blue cells, as shown below:

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This includes the transaction date, face amount of bonds issued, stated rate or coupon rate, issue amount, redemption date, face amount of bonds redeemed, and market price at redemption. In addition, the number of months passed from the date of the bonds to the issue date and the number of months passed since the last interest payment date and the date of the redemption. (As mentioned earlier, we are using dates as of the beginning of the month. One reason is that we don’t need to enter partial months.)

Once these variables are entered, the fields in the Input Variables boxes in the three amortization table worksheets will be automatically filled in. However, the yield for each of the three amortization tables will have to be updated using the Goal Seek function, exactly as we did in the Student Project Template.xlsx spreadsheet. Once done, the spreadsheet will automatically prepare the required journal entries. Note that there are two journal entry tabs; one for bonds issued at a premium and another for bonds issued at a discount.

CLOSING COMMENTS

Student Comments

Students were asked to critique this project. As expected, there were positive as well as negative reactions to the project. A consistent theme among the favorable responses was that, despite or because of the difficulty of the project, it helped deepen their understanding of the concepts surrounding the accounting for bonds. While administration of this project requires the instructor to gain sufficient familiarity with the spreadsheets, it appears that the effort provides a clear benefit to the students.

Limitations of the Amortization Spreadsheet

While the Student Project Template.xlsx is rather flexible, it can accommodate multiple interest payments per year and up to 1,000 amortization periods, it does have some limitations. While individual transactions to issue the bonds can take place on any day during the month, it does assume that interest payments and bond maturities occur at the end of a month. The Bond Project Solution.xlsx spreadsheet, however, has been created to specifically deal with the variables of the project that are held constant and the specific journal entries required by the project and is therefore much less flexible.

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APPENDIX 1

Intermediate Accounting – Bond Project

Team Members: ______________________________

_______________________________

You are a senior accountant in the Albuquerque office of Chen, Johnson and Sanchez, a southwest regional CPA firm. One of your clients, Stanton Company, has recently gone through a bond issuance. Selected information from the bond indenture for that issuance is as follows:

Face amount $1,500,000

Coupon rate 7%

Interest payment dates Annually, December 31

Maturity date December 31, 2024

The bonds had an issue date of January 1, 2015, but as funds were not needed immediately, they were not taken to market until October 1, 2015. On that date, they were issued at 101.3, plus accrued interest.

Critical dates requiring journal entries:

October 1, 2015 – Issuance of bonds at 101.3 plus accrued interest

December 31, 2015 – Payment of interest

December 31, 2016 – Payment of interest

April 1, 2017 – Bonds with a face value of $600,000 were purchased in the market at 102 plus accrued interest, and retired.

December 31, 2017 – Payment of interest on remaining bonds.

Required:

1. The client company has recorded these transactions using the straight-line method of amortizing the premium and recording interest expense. Recreate the journal entries the client would have made for each of the above critical dates.

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2. Research the accounting standards codification to determine the appropriate method of accounting for these transactions. Report the results of your research, appropriately citing the codification. Also, provide the FASB’s definition of “imputed interest”.

3. Prepare the proper journal entries for each of the above critical dates, assuming the effective interest method. Use the Student Project Tempate spreadsheet, which is being made available to you to prepare the underlying amortization tables. Refer to the tutorial for use of the spreadsheet below. I have made some minor changes to the spreadsheet to accommodate the data as presented in this case.

4. Comment on the appropriateness of the method used by your client company

Tutorial: Using Student Project Template.xlsx

For purposes of this project, you will want to access the spreadsheet Student Project Template.xlsx.

In the blue/green colored box entitled “Input Variables” in the upper left hand corner of the spreadsheet, enter the variables as specified on the first page of this assignment. This block has a cell for each of the variables relevant to your case. Some of those variables relate to the variables that would be presented in the bond indenture (Maturity date, Interest payments per year, face amount of bonds issued, stated interest rate); others would relate to variables determined on the actual date of issue (Market value of the bonds and Transaction date, or date the bonds were actually issued).

Once the variables are entered, the amortization table will be filled out. The size of the amortization table (that is, the number of rows contained) will vary, depending on maturity date, payments per year, and so forth. However, the discount or premium may not be properly amortized. You can tell if this is the case if the bottom right number in the table does not equal the face amount of the bond. To fix this, we need to invoke the Goal Seek function of Excel. Do this by moving your curser to that bottom right cell of the amortization table. Invoke the Goal Seek function by entering dAta, What if analysis and Goalseek (or alt-a, w, g), and in the dialog box, tab to the second field and enter the face amount of the bonds, tab to the third field and enter cell G20 and then enter, twice. The discount or premium should now be properly amortized. You can tell this if the value in that cell now equals the face amount of the bonds.

Once you enter the variable amounts in the Variable block on the spreadsheet, the spreadsheet will calculate the amount of interest that has accrued and the amount of cash received at issuance of the bonds, and will be among the information presented in the Worksheet Calculations block on the spreadsheet. Note that the accrued interest amount calculated by the spreadsheet may be different from the amount you calculated for the “Straight-line” requirement of this case. This is because the spreadsheet counts actual days

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in its calculation and you probably counted months for your computation, which will be sufficient for the purposes of this case.

APPENDIX 2

 

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APPENDIX 3

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