Chapter 11 - Solution Manual

This difference is disclosed on the balance sheet as

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bondholders do not receive this portion of the "effective" interest until maturity. This difference is disclosed on the balance sheet as a contra liability in the Discount on Bonds Payable account. c. The $10,000 increase in the market value of the bonds from January I to June 30 is primarily the result of a decrease in the rate of interest at which the Company's bonds will trade in the market. The decrease in the market rate of interest at which the bonds will trade may be due to a general change in the conditions of the bond market, to a change in the Company's credit ratings or to a combination of the two. A minor portion of the increase is due to the fact that the bonds were issued at a discount and are now six months closer to maturity. This portion of the increase is due only to the passage of time and would have taken place without any change in the market rate of interest. In other words, assuming no change in the market rate of interest, the market value of the bonds will increase gradually from $975,000 to $1,000,000 at maturity because of the increase in the present value of the unpaid but accruing interest (discount) of $25,000. Assuming the discount is accumulated on an interest basis, this position of the increase in the market value of the bonds will be reported in the Company's financial statements. The portion of the increase in the market value of the bonds which is due to the decrease in the market rate of interest, though not reported in the financial statements, is significant because only by comparing the effective rate of interest at which the bonds were issued with the current market rate of interest can the Company judge whether or not the rate they are paying is advantageous to them. If the market rate is lower it may be to the Company's advantage to refund the old issue even though the funding itself would result in a loss. d. $975,625. This basis for valuing the bond liability--its effective amount as at the date of the issue, plus accumulated discount on a straight-line basis for the six months since then--is theoretically superior to the other three. It would; however, be more precise to accumulate the discount on an interest basis. The Company actually borrowed $975,000, and the immediate liability incurred cannot be more nor less than this amount. The present value of the bond liability is less than maturity value because the effective rate of interest is greater than the nominal rate which appears on the face of the bonds. The actual difference between the present value of the bond liability at the date of issue ($975,000) and its maturity value ($1,000,000) represents that portion of the effective interest on the amount borrowed ($975,000) that will not be paid until maturity. As this amount
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213 is accumulated by charges to interest expense and credits to the bond liability, the effective amount of the liability gradually approaches maturity value.
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